18th May 2015
With an ever increasing number of retirees separating and divorcing, David Smith, financial planning director at Tilney Bestinvest, looks at the impact the new pension freedoms are likely to have…
The new Pension Freedoms should make divorce settlements far more straightforward for the over 55s. To date the biggest problem with divorce settlements has been the fact that the largest assets are typically pensions and property. This has proved a serious issue as pension funds have been of limited immediate value in the past; after all, only 25% could typically be taken as a lump sum with the remaining 75% having to be used to provide a capped level of income.
This created an anomaly in that both parties valued a property worth, say, £500,000 far more than a £500,000 pension fund. After all, the property is of tangible value and could be sold at any time, whilst a £500k pension fund could only generate a tax free cash lump sum of £125,000 and the remaining pension pot might have generated an income of as little £20,000 per annum gross.
Settlements in such situations were therefore invariably difficult and would often result in the pension being split and the property being sold with the proceeds subsequently distributed – an outcome neither party often desired.
Moving forward however and today pension funds have far more ‘real value’; 25% can still be taken tax free, whilst the remaining 75% can be taken as a one-off, or series of uncapped payments. Of course any payments in excess of 25% will be subject to income tax but at least the new pension reform rules allow pensions to be valued as capital assets rather than income-producing assets.
There are three ways in which pension benefits can be dealt with as part of a divorce settlement: offsetting, earmarking or sharing:
This is the oldest and still most commonly used method of dealing with pension benefits. Quite simply, the couple keep their own pension rights with the value being offset against other assets – so if the husband has significant pension rights he will keep these in their entirety but his spouse will get a larger share of other assets, for example the marital home, to reflect this.
Pensions earmarking is effectively a form of deferred maintenance payment. Therefore, all or part of the pension benefits of one party are ordered to be paid to the other spouse. When a pension earmarking order applies, the pension paid to the ex-spouse will be taxed at the rate(s) appropriate to the member. Furthermore, earmarked benefits are assessed against the member’s lifetime allowance.
3. Pension sharing
Typically a pension sharing order will result in the ex-spouse receiving a proportion of the member’s pension fund. Depending upon the scheme providing the member’s benefits, the sum to be shared may either be used to provide benefits for the ex-spouse under the member’s scheme or be transferred to a scheme of the ex-spouse’s choice.
The new rules should mean that many divorcing couples are no longer, in effect, forced to sell property: pensions now have a real tangible capital value so the distribution of assets should become far more straightforward. Unfortunately however, if one or both of the parties are members of an unfunded Statutory Scheme such as the Civil Service Scheme, the same old problems still exist, as such arrangements are not subject to the Pension Reform rules.