The authors of this article argue that without proper advice, pension offsetting, rather than pension sharing, could allow the inequality in pension wealth to continue long after a couple’s divorce. 

We regularly carry guest commentaries from lawyers about the complexities of HNW divorce. And it seems that the well never runs dry when it comes to new ways for couples to come into conflict. Well, what about pensions and arguments over who gets what from a pension fund? 

In this article, David Lillywhite and Eno Elezi, Burgess Mee Family Law, discuss the issues at stake. The editors at WealthBriefing are pleased to share these views and, of course, the usual editorial disclaimers apply to views of outside contributors. Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

The issue of pensions on divorce is a complicated and often overlooked area of the financial aspect of a separation. 

In 2000, the Welfare Reform and Pension Act 1999 came into effect, which gives the court the power to make pension sharing orders. This means that the court can divide the rights under a pension scheme (or schemes) between separating parties, thus transferring the pension rights currently held by one party to the other. 

Pension offsetting
Many lawyers and clients will be familiar with the concept of pension sharing when a pension pot is divided and transferred between spouses. But that is not the only way in which pensions can be divided on separation – offsetting is also a potential mechanism by which needs can be met, where one spouse trades their rights to the other spouse’s pension in favour of capital that they will receive much sooner.

However, there are pitfalls to pension off-setting so specialist advice should always be sought before pursuing this approach as part of an overall agreement.

In 2019 the Pensions Advisory Group (“PAG”) published its long-awaited final report, providing much-needed guidance for family lawyers on how to deal with pensions. The report addresses the topic of offsetting and includes warnings for practitioners to consider. 

Pension offsetting can be explained by way of a simplified example. The wife has built up a pension pot with a cash equivalent value (“CE value”) of £200,000 ($265,506). The husband does not have a pension. This was a long marriage and therefore, in general terms, the starting point will be one of equality (whether by way of capital or income in retirement). 

The husband, however, is happy to forgo his entitlement to a pension share in order to receive more capital now. Rather than sharing the pension, the parties might therefore agree to offset the husband’s entitlement to share in the pension against the other capital in the case, which is usually with reference to the parties’ interest in the family home. He might, for example, retain £100,000 more of the net proceeds of sale.  

What are the risks with pension offsetting?
It is easy to see the attractiveness of this approach, and its practicality: if it is what both parties want, then it may make a settlement that much more feasible. However, it only achieves a fair outcome if the pension is accurately valued. 

Firstly, the CE value provided by many schemes does not necessarily provide an accurate valuation. Pensions are not capital assets in the same way that a bank account or a property is (i.e. they should not be treated pound-for-pound), and their value also depends on the type of pension scheme. For example, the two broad categories of pension are defined benefit and defined contribution schemes. Defined contribution schemes are based on what contributions have been made. Defined benefit schemes define the retirement benefits. 

The PAG report explains that if the pensions involved are solely defined contribution funds, which have no guarantees, the CE value can often be relied upon. In the case of a defined benefit scheme, CE values are often not reliable and a specialist should be instructed to resolve the ‘true’ value of the scheme. 
 

For this same reason, the PAG report points out the CE value of a defined contribution scheme is often not comparable to the CE value of a defined benefit scheme; and the CE values of two different defined benefit schemes may not be comparable themselves. Thus, pension offsetting based on CE values between two spouses in the context where one has a defined benefit scheme and the other a defined contribution scheme, or each spouse has a different defined benefit scheme, is likely to produce an unfair outcome. It is important to stress that there is no “one-size-fits-all” approach. In scenarios like the above, the PAG report suggests that “pensions on divorce expert” input is likely to be required. A PODE report is essentially an expert opinion on the value of the pensions in question. Whilst this will increase costs, a PODE report ensures that any pension offsetting agreement is predicated on accurate valuations of the pensions, thus avoiding the risks outlined above.

A second issue is taxation. Pensions typically allow for a tax-free lump sum drawdown of a certain percentage, with the rest drawn as income and taxed. Simply taking the CE value as the value of the pension does not take into account the potential tax implications. Further, the party receiving the non-pension assets in lieu may be obtaining a tax advantage if the non-pension assets they retain are not subject to tax.  

A third point to consider is whether to factor in a “utility discount.” Receiving capital now as opposed to income/capital from a pension fund in the future is more valuable in economic terms. Therefore, the capital sum retained by the spouse forgoing their right to share in the other’s pension might need to be reduced to reflect this fact. 

Inequality of pensions
The importance of pensions on divorce cannot be overstated. Pensions provide security for retirement: if one spouse is giving up an entitlement to the other’s pension, it is therefore crucial that they understand the value of what they are sacrificing.

According to a recent report by the University of Manchester (Pensions and Divorce: Exploratory Analysis of Quantitative Data, Manchester Institute for Collaborative Research on Ageing) pension wealth is not generally shared equally between spouses, with men tending to have the majority. Further, the report found that in almost half of couples with pensions, one spouse held 90 per cent of the pension wealth.

The tendency for the spouse who built up the pension to want to retain it, and the spouse who did not to be willing to give it up for non-pension assets is reflected in the report, with divorced women’s pensions generally much lower than divorced men’s. Yet pension wealth typically exceeds property wealth in higher income households, especially outside London.

Without proper advice, therefore, pension offsetting, rather than pension sharing, could allow the inequality in pension wealth to continue long after a couple’s divorce.