Pension simplification in 2006 and then pension freedoms in 2015 have changed the face of retirement so significantly that their impact on other areas such as divorce just can’t be ignored. We still technically have three options to deal with pensions in divorce settlements, offsetting, earmarking and pension sharing but are they all still viable in today’s pension landscape? All the options are impacted differently by the changes we have seen since A-day and may need reviewing if possible.
Offsetting pensions against other assets is the easiest way to deal with pensions in a divorce and as it has no impact on either spouse’s lifetime limits or pension protections, you would have thought that it might be the most preferable way to deal with things. However, there are issues that may arise in the case of offsetting today that may well not have been an issue a number of years ago. The biggest issue is funding pensions going forward for the ex-spouse with little or no pension due to the reduction of the annual allowance.
Earmarking or Attachment Orders were the forerunner to pension sharing and was the only option (other than offsetting) prior to the Welfare Reform and Pensions Act 1999. Earmarking orders were typically drafted to make a lump sum payment or pay a percentage of income to the ex-spouse when the pension is in payment. The flaw in the system was that the decision when to draw benefits was at the discretion of the member, (unless it was specified in the Order, which was rare) so if the divorce was acrimonious, the member could delay drawing the pension or not draw it at all. Earmarking Orders ceased on the member’s death or remarriage of the ex-spouse.
Earmarking Orders were drafted at a time when pension freedoms and flexibility was never envisaged and these new freedoms, such as drawling a UFPLS or nil income from flexi access drawdown, can have the unintended consequences of circumventing the requirements set out in the Order, unless the details in the order are very specific.
In most cases the Order will cease on death so they won’t receive anything at that point either. This is because Earmarking Orders just specify the amount of PCLS or income that has to be passed over to the ex-spouse when they are accessed and don’t give a deadline to access them. The flexibility of income is also an issue because what the ex-spouse thought would be a regular income in retirement could very well not be, it could be erratic or a single lump that will be taxed at the original member’s marginal rate of tax, which is unlikely to be beneficial to the ex-spouse. It is possible that the ex-spouse never receives benefits if the original member chooses not to access them.
Because of this, Earmarking Orders really should be confined to the history books and where there have been historical Earmarking Orders put in place, if they can be replaced by a Pension Sharing Order, it should be at least investigated. The biggest issues with Earmarking is the lack of a clean break and the fact that the original pension member still remains in control of the pension entirely.
On the flip side of this, the original member will be restricted on the pension they can build because all the benefits remain theirs and are tested against their lifetime allowance even though they shouldn’t benefit from the whole income in retirement. The ex-spouse however is able to build up funds in their own name using their own lifetime allowance irrespective of what they may receive because of the Earmarking Order.
Pension sharing is the more modern option, generally used by most instead of Earmarking these days because of the clean break that it gives. There are still issues to be considered when opting for a pension share, which can have impacts on both parties. In most cases the member will be able to remain in the scheme that they are in and the ex-spouse will need to take advice to decide where the benefits should be held after the Sharing Order is in place. The ex-spouse may also need ongoing financial and investment advice to ensure that the benefits provide as intended at retirement.
The Sharing Order will mean that the benefits of the original member are reduced and given to the ex-spouse, this could cause both lifetime allowance issues in the short and long term.
Sharing of state pension or national insurance records has previously been possible, but since the introduction of the new state pension this has been severely restricted. For those who reach state pension age after 6 April 2016, it is only possible to share the protected pension amount which in many cases will be very small because it is the difference between the starting rate (the amount you would get under the old state pension rules at 6 April 2016) and the new state pension rate.
Transitional protections and the LTA
Sharing or Earmarking pensions on divorce will clearly have an impact on the ability for both parties to build up pension funds in the future. Although Earmarking uses up the original members lifetime allowance because no funds move to the ex-spouse there is no impact on any of the transitional protections.
Pension sharing can be more complex and all the implications of the Sharing Order need to be considered before the Order is put in place or funds are put into pensions to rebuild the original members retirement plans.
For those with primary protection, if too much is given away to the ex-spouse then they may well lose Primary protection even though they still have benefits in excess of the lifetime allowance. What actually happens is the amount that is given to the ex-spouse is taken off the value used for primary protection (no account is taken of any growth since A-day) and if this brings the value to below £1.5m then primary protection is lost. If the funds have grown significantly since A-day then it is very likely that primary protection will be lost but the original member will still have benefits worth in excess of the lifetime allowance. However, should the recalculated primary protection figure still be in excess of £1.5m the original member will retain primary protection but with a recalculated factor, this doesn’t impact on any protected tax free cash if primary protection of any level is retained.
The receiving ex-spouse could lose their enhanced protection if the monies aren’t transferred into an existing pension, this is a real issue if the original member is in a scheme that doesn’t allow pension credits to leave the scheme but it will be rare that someone receiving a pension credit would already have such significant benefits themselves.
It may also be possible to the receiving ex-spouse to claim extra lifetime allowance, but this is only possible if the benefits being shared were crystallised and the divorce occurred after A-day. The reason behind this is to avoid the funds being tested twice. They will actually be tested twice but the ex-spouse will have their lifetime allowance increased by the amount that they have received in the Sharing Order.