Pensions and divorce — understanding pension sharing orders and pension credits

One of the biggest areas of contention when it comes to divorce is the financial split. Many of these disagreements stem from the fact that even just working out what an equitable share looks like is a complex undertaking.

Splitting assets based purely on their current value may be the obvious solution, but this approach has the potential to leave one person at a significant financial disadvantage. Perhaps the most common example is with pensions, which can be hard to compare to other assets like taxable accounts or the family home.

Pension assets can be split using pension sharing orders, but the large number of different pension types, and the variations in tax treatment that apply, make it challenging to understand their true value and decide on a fair financial split.

Here, we’re looking at the details of pensions and divorce, covering how pension sharing orders work and what you should consider if you’re expecting to be in receipt of a pension credit from your ex-partner.

A pension sharing order is an agreement made as part of a financial split in a divorce, where a portion of a pension scheme is allocated to the other partner. Splitting pension assets is common in divorce, as many households have one person with a significantly higher pension balance than the other.

In many divorces, particularly if children are involved, one partner will want to keep the family home. On face value, it might seem fair for a defined contribution (DC) pension worth £1 million to offset a home worth £1 million, but as mentioned earlier, this isn’t often the case.

The true value of a pension needs to consider the future tax-effective growth of the asset, as well as the potential tax-free lump sum and taxable future income stream it will provide. The situation is even more complex for defined benefit (DB) schemes such as final salary pensions, which generally can’t be cashed in for a lump sum, but provide a very valuable guaranteed income stream in retirement.

A properly calculated pension sharing order should consider all this detail to allow both parties to reach an accurate valuation of any pensions assets and help inform a fair financial split.

This process will generally involve the need for what is known as a cash equivalent transfer value (CETV) for any DB schemes, and up to date valuations for any DC schemes.

For the majority of our clients, a financial split results in a pension credit being received by one partner.

A pension credit is an amount of a pension scheme which is to be transferred from one ex-partner to another as a result of a financial split on divorce.

A pension credit can be applied to any type of scheme, but the way the credit will work in practical terms will be different based on the makeup of the scheme.

The first key question with a new pension credit is whether the receiving person will remain a member of the original scheme, or whether they will be receiving a lump sum that will need to be transferred into a new scheme.

For those who will be remaining a member of their ex-partner’s scheme, this is known as an internal credit, while a transfer to a new scheme is an external credit.

External credit

An external credit is usually the default option for most pension schemes. In this case, an amount will be made available for a transfer and the receiver will need to arrange for an appropriate scheme to receive the pension credit funds.

For example, if one person had a pension worth £600,000 which was to be split equally, £300,000 would become a pension credit to be transferred to a new scheme.

There are many important questions to consider when it comes to how to manage this transfer amount, which we’ll cover in more detail below.

Internal credit

Internal credits are less common, and generally only apply to unfunded public sector schemes such as the NHS or teacher’s pension schemes. In these cases, it’s not possible to transfer the pension credit to an alternative provider.

Instead, the receiving person will be added to the scheme as a shadow member and will receive a proportionate amount of their ex-partners benefits.

This means that on retirement, the receiver of the pension credit would receive a guaranteed income stream based on the agreed percentage of the total value. For example, an NHS pension worth £22,000 per year on retirement with a 50% pension credit may provide the receiver with around £11,000 per year from the scheme.

The difference here is that the member’s benefit will reduce by 50%, but the 50% for the spouse will be revalued taking into account their age so the actual credit could end up a little higher or lower than 50%.

For a large percentage of clients who we help with financial planning through a divorce, it is one member of the couple who holds the majority of the pension assets, who deals with the financial matters for the household, or both.

This often leads to the person receiving a pension credit having to consider many financial planning questions that they’ve never had to before. There are a few key areas to consider if you’re in this situation.

Allocating your pension credit

The first point is where to put the pension credit. If you’re going to be receiving an external pension credit, the member’s pension scheme will send out a transfer discharge form once they receive the pension sharing order. You’ll need to inform your ex-partner’s pension scheme where they are to transfer the funds.

This could be to an existing pension you already have setup, or you could look to open a new scheme to receive the pension credit. To make this decision, you’ll have to weigh up things like the level of fees and charges on any existing schemes, whether you’re currently receiving employer contributions and how you would like to structure your investments.

Making investment decisions

This may be the first time you’ve had to actively make any investment decisions. There are various aspects to consider, such as the amount of time you have until you plan to retire, the level of risk you’re willing to take, the level of return you’re trying to achieve and any other specific investment considerations such as ethical or religious preferences.

Planning for retirement

Before you can make any final decisions on how to invest a pension credit, you’ll need to understand what your retirement plan looks like. For example, your investment choices will look very different if you plan to retire immediately than if you don’t plan to retire for another 10 years.

Managing the finer details

In addition to these fundamentals, there could be a number of technical details that also need close review. Some examples can include the decisions on how to take your benefits if you are close to retirement (i.e. a fixed guaranteed annuity or flexible income drawdown without a guarantee) or considering any disqualifying credit that would reduce the amount of tax-free cash you have access to if your ex-partner has already withdrawn it prior to the split.

These are all questions that a financial planner can help you work through. At Evelyn Partners, we can assist with both the financial planning and investment management aspects through our combined wealth management approach.

The process of completing a financial split and pension sharing order can be lengthy and frustrating. It’s no surprise that once an agreement has been made, clients want the pension credit to be dealt with as soon as possible.

However, there are issues that can cause the process to take longer than anticipated. The good news is that there are ways to avoid these pitfalls if you plan ahead.

Understanding the advice process

The first issue which can arise is expectations around how long the advice process can take. Financial advice is heavily regulated and there are a number of specific steps that need to be taken for advice to be given. This includes the completion of a fact find document, working through the risk profile questionnaire, gathering information from your existing pension and investment providers and implementing the advice once you have accepted it.

This process can take some time, and much of this time is outside the control of your financial planner. For example, some pension providers can take up to a month or more just to provide a breakdown of current charges and fund information.

Start early

The good news is that this timing factor can be mitigated by starting the process early. You don’t have to have all of the final information in order to begin the advice process. For example, you may not know exactly how much your final pension credit will be, but you will likely have a ballpark estimate.

Even with a rough level of detail, you can begin to work with a financial planner to discuss your retirement planning objectives, your attitude to risk and your investment preferences. They can also start gathering information on your existing investments and pensions, so that once the pension sharing order is finalised, the advice process is well underway.

This can also help you to quantify what you need to meet your financial goals, which can help inform your discussions with your solicitor on the level of financial split you’re looking to achieve.

Interim investment risk

Once a pension credit has been approved, there will likely be a period of time before the funds can be transferred to your chosen scheme. During this period, the funds may be invested in a way that is not in line with your attitude to risk and financial goals and objectives.

It may be possible to make changes to the investments in the short term before they are transferred, to reduce or remove this risk. If you don’t consider this interim risk, the amount that’s transferred may be less than what you expected.

Going through a divorce and financial split is never easy, and pension sharing orders and pension credits add a layer of technical complexity on top of the emotional challenges.

At Evelyn Partners, we can help remove that complexity to help you better understand your financial situation both now and into the future. To discuss your options, you can book a complimentary initial consultation online or call 020 7189 2400.