01 December 2020
Ian Neale, director at Aries Insight, provides an introduction to this challenging and complex issue
A disproportionate number of the queries we receive about pensions legislation concern the treatment of pension rights on divorce. It’s no wonder, because the law here is a particularly challenging morass for the different parties involved, including the courts, the pension scheme administrator, the trustees, the divorcing couple and their advisers.
The main rules and procedures governing divorce in England and Wales are laid down in the Matrimonial Causes Act 1973 and the Family Procedure Rules 2010 (https://bit.ly/3eP6QnX). In Scotland, the main legislation governing the financial aspects of divorce is the Family Law (Scotland) Act 1985. In both, the options for dealing with pension rights on dissolution of a civil partnership are the same as apply on divorce.
There are four main ways of dealing with any pension rights in a divorce (none of which are mandatory):
- one party can make a lump sum payment to the other
- the rights can be offset against other assets of the divorcing parties
- the rights can be subject to an earmarking (also known as ‘pension attachment’) order
- the rights can be subject to a pension sharing order.
- It is important to note that ‘earmarking’ or sharing of UK pension rights cannot be ordered by an overseas court (even though a settlement made by an overseas court may purport to do so). Conversely, where an individual has pension benefits that are held overseas, it is not possible for a UK court to make a pension sharing or earmarking order against those benefits.
Earmarking has been available to divorcing parties since 1 July 1996. When the pension rights come into payment, a percentage as defined in the earmarking order is paid direct to the former spouse. The member remains liable for income tax on the whole pension; the ex-spouse has no liability at all. In England and Wales, both pensions and lump sums (on retirement or death) can be earmarked. Under Scottish law, only lump sums can be earmarked.
There are a number of problems with the earmarking approach, as follows, and in practice it is not used widely.
There is uncertainty about the eventual payment of the benefits – because, if the scheme member dies before retiring, or if the ex-spouse marries or forms a civil partnership, any earmarking order (other than for lump sum death benefits) ceases to apply.
The earmarked payments do not start until the member retires – a problem if the ex-spouse is older than the member, or if the member delays the retirement date.
If the member retires early on reduced pension, then the earmarked payments will also be reduced, yielding the ex-spouse a lower annual pension than might have been expected.
The payments cease on the member’s death, thus leaving the ex-spouse without that income for the last years of life, when need may well be greatest.
Earmarking does not fit with the clean-break approach to divorce/dissolution, as generally favoured by law and courts in the UK.
The pension sharing option was introduced from 1 December 2000. The member’s pension rights are divided at the time of the divorce: a pension sharing order specifies a certain percentage (in Scotland, an amount or percentage) to be removed and secured for the ex-spouse as part of the settlement. The rights so secured form immediate or deferred benefits for the ex-spouse, independent from the member’s remaining rights.
In technical terms, a ‘pension debit’ is created against the member’s rights, matched by the creation of a ‘pension credit’ for the former spouse which becomes payable when they reach retirement age. Usually the ex-spouse will have the right to transfer the pension share to another pension arrangement, in which case they will be required to nominate the destination.
However, the trustees of the member’s scheme may choose to offer an internal transfer within the scheme, where it would be treated rather like any other pension or deferred pension. In this case, the ex-spouse will have the choice of whether to remain in the member’s scheme or to transfer out.
In practice, in England and Wales, a pension sharing order will be accompanied by a pension sharing annex (Form P1) giving details of the member, the ex-spouse, the pension scheme to which the annex relates, the percentage of the benefits to be shared and the date on which the sharing order takes effect. This must be sent to the pension scheme trustees within seven days.
Since – unlike earmarking – pension sharing does fit well with the clean-break principle, and does secure pension rights for the ex-spouse at the time of the divorce, it is more widely used than earmarking. However, lump sum payments and offsetting also have their advantages, and will undoubtedly continue to be used in many cases.
Featured in the December 2020 - January 2021 issue of Professional in Payroll, Pensions and Reward. Correct at time of publication.