Pension offsetting on divorce – where and when not to use it
Martin Jones, technical team leader at AJ Bell, looks at when offsetting might be a useful solution and when it’s best avoided
Generally speaking, there are three ways of dealing with pensions on divorce – these being offsetting, earmarking and sharing.
Offsetting is not specifically defined in legislation, but it’s broadly understood to mean Spouse A keeping all of their pension(s) while agreeing to transfer other property or assets to Spouse B. (Pension sharing and earmarking on the other hand, both involve some of the pension funds being transferred or paid to the other spouse.)
While, sharing and earmarking can seem complicated and costly, transferring an asset like a family home is a transaction that most clients are familiar with. So it’s no surprise that offsetting is typically perceived to be the most straightforward option of the three.
This preference is also borne out by statistics. While the number of court orders involving sharing and earmarking has increased steadily over the last five years, property adjustment orders and lump sum orders still account for more than 50 per cent of all court orders on divorce.
Admittedly, the figures for sharing and earmarking might be lower because pensions are simply overlooked, but it points towards offsetting still being the most common way of dealing with pensions at the end of a marriage.
Appearances can be deceptive, however, and the offsetting decision can be more complex than it first seems, which can lead to potentially unfair outcomes further down the line.
So what are the challenges?
The first and most obvious challenge is how you compare a pension with other assets given they’re valued on a completely different basis.
This is particularly true of defined benefit (DB) pensions. Here, there is no identifiable pot of investments but rather a promise of a future lump sum and income stream. Yet for divorce purposes, the scheme actuary is required to attribute a capital value or Cash Equivalent Transfer Value (CETV) to the DB pension.
Whether the CETV is helpful or not when making a decision is debatable. The CETV is often the amount the scheme would pay to settle its liability, rather than an attempt to produce any kind of accurate assessment of the true value of the pension. Different pension schemes use different actuarial factors to calculate the CETV. It’s also difficult to quantify the value of a lifetime guarantee.
There is also an issue of perception and bias, as individuals often undervalue the inherent hedging against longevity risk that comes with a guaranteed income, particularly when offered the choice of a cash lump sum in exchange.
Even comparing defined contribution (DC) pension values with other assets might not be as straightforward as it seems.
A DC pension scheme is not subject to capital gains tax or income tax, so it differs in its tax treatment from other assets. It can receive subsequent contributions that will be boosted by tax relief. There’s also a question mark over how to account for the fact that at some point the client will be taking benefits, thus reducing the value of the pension.
Furthermore, 75 per cent of those benefits will be subject to income tax on withdrawal, and these withdrawals could take place over several years based on ever-changing tax rates and bands. So while you can put a capital value on a DC scheme, it’s still very much a moving target.
So when to use?
Despite there being risks, there are still situations where offsetting may be a viable solution.
The first and most obvious situation is where the other main asset of the marriage (other than the pension) is the matrimonial home. For reasons of expediency and practicality, the spouse without the pension may prefer to stay living in the matrimonial home and receive full ownership. In other words, the property itself is of more value to the spouse than its actual monetary value.
If the pension is largely invested in an illiquid asset, such as a commercial property, it would be challenging (if not impossible) to implement pension sharing or earmarking. This is particularly true in the case of a small self-administered scheme (SSAS) where the property is being let to the sponsoring employer.
Other less common scenarios are when the pension is overseas, meaning it cannot be subject to a pension sharing order, and when the parties divorced before earmarking (1996) and sharing (2000) became available.
It’s also interesting to note that negligence claims against lawyers are higher for cases involving offsetting than those dealing with earmarking or sharing. Therefore, if you’re advising a spouse for whom offsetting is looking like the best option, make sure to fully document the rationale behind the advice just in case it’s challenged later on.