Pensions on Divorce – Confusing Terminology and the Difficulties With Approach

It does seem remarkable to reflect on the fact that prior to 1996 the courts had no powers, on a divorce, to share or directly attack the pension rights held by one or both parties.

In 1996, pension earmarking was introduced. This meant that if Harry, now retired and receiving an annual net pension of GBP60,000 as a member of the Armed Forces Pension Scheme, divorced Sally, the scheme could be ordered to pay her, for example, 50% of the pension in payment.

This solution, however, offered only limited protection.

If Harry died before Sally, the payments to her would cease entirely, leaving her financially vulnerable.

From December 2000, the law developed further to allow pension sharing. A pension sharing order over Harry’s Armed Forces pension could divert 50% of the pension income to Sally for the rest of her life. Crucially, this entitlement would be independent of Harry’s and would therefore continue even if Harry predeceased her.

Do people understand pensions?

Before considering what a pension actually is, and why this matters on divorce, it is worth noting that evidence suggests far fewer pension sharing orders are made on divorce than would be expected – particularly given that pensions are often the largest and most valuable asset in the marital finances.

This appears to stem from a widespread lack of understanding about how pensions operate.

Some research also indicates that divorcing couples often believe that a pension “belongs” to the spouse who contributed to it.

What is a pension and why does it matter?

On divorce, the category into which an asset falls may determine how that asset is treated. In broad terms:

• matrimonial capital assets are usually shared between the parties as of right (regardless of need); whereas
• income is not shared as of right – maintenance is paid from income only where there is a demonstrated need.

So into which category does a pension fall?

Is there a clear definition of a pension?

The simple answer is no. There is no statutory definition in the legislation governing pension treatment on divorce.

Judges have expressed differing views about what a pension actually represents.

Pensions can generate capital (such as tax‑free lump sums) and income (for example, through annuities). They are often complex assets with features that set them apart from ordinary capital or income streams.

Dictionary definitions provide only limited guidance.

Cambridge Dictionary:

“An amount of money paid regularly by the government or a private company to a person who does not work anymore because they are too old or have become ill.”

Oxford Dictionary:

“An amount of money paid regularly by a government or company to somebody who has retired from work.”

Do court decisions provide clarity on how pensions should be treated?

In short, no.

Judges have long recognised that pensions do not comfortably fit into either the capital or income category. This is because pensions often offer options beyond a simple income stream.

Complications increased after reforms introduced by the Taxation of Pensions Act 2014, which from 6 April 2015 allowed members of defined contribution schemes aged 55 or over to access their pensions early. Options include:

• withdrawing up to 25% of the pension tax‑free; or
• using flexi-access drawdown.

These choices have forced the courts to consider both the flexibility available to the pension holder and the nature of the underlying asset.

A solution

I have long believed that attempts to categorise pensions on divorce are misguided. Lawyers and judges should accept that pensions are unique assets.

Their treatment will depend on many factors, including:

• whether the pension member has already retired and is receiving pension income (as with Harry);
• whether the parties are young (eg, in their early 30s), in which case pensions may be less significant because they have many years to contribute;
• whether the pension is held abroad, in which case the English Court cannot make a pension sharing order;
• whether the pension scheme is underfunded, creating uncertainty about future payouts; or
• whether the pension is part of a “gold‑plated” scheme offering guaranteed, generous, inflation‑proofed benefits.

If there has to be a definition, then perhaps we should accept that it is more useful to define a pension as a form of deferred pay – a mechanism enabling someone to defer gratification from earnings today in favour of enjoying these in some form when one is unable to work.

The problems associated with valuing pensions on divorce

In every divorce where finances must be addressed, all assets must be valued before the parties or the court can decide how they should be shared.

Valuing a pension on divorce, however, can be particularly complex.

Returning to Harry and Sally:

• If Harry is retired and receiving GBP60,000 per annum net, should GBP1 of pension be treated the same as GBP1 in a bank account?
• How should the court value this GBP60,000 annual income? Does it have a capital value?

Consider each question.

• One option for Sally is to receive capital (such as cash or property) instead of sharing Harry’s pension. This is known as offsetting.
• Offsetting is technically complex and carries professional negligence risks.
• Harry’s pension guarantees him income for life.
• He bears no investment risk – the scheme is contractually obliged to pay him.
• If Sally receives cash instead, will it last throughout her lifetime?
• What if she outlives her expected life span?
• What if investment returns underperform?
• What will future inflation be?
• Sally will likely face professional fees for investment and financial advice.

This illustrates that offsetting can be risky and that GBP1 of pension in Harry’s scheme is usually worth more than GBP1 of cash in Sally’s bank account.

The court will therefore need a value for Harry’s pension.

• Harry belongs to a defined benefit scheme, which provides a guaranteed income in retirement.
• A defined contribution scheme simply reflects funds paid in and investment growth.
• Valuation methods differ significantly between the two types.
• Defined contribution valuations are straightforward – the pot value is the value.
• Defined benefit valuations are far more difficult.
• The terminology used in pension valuation is complex.
• A wide array of specialist terms are used, including:

1. best estimate market consistent capital value;
2. defined contribution fund equivalent;
3. fair actuarial value;
4. full value;
5. money purchase equivalent value;
6. open market value; and
7. cash equivalent transfer value (and variations).
• Often, the stated value of a defined benefit scheme (such as Harry’s) does not reflect its true economic value. Consider:

1. annual inflation-linked increases;
2. guaranteed lifetime income;
3. no charges for administering the scheme; and
4. additional dependants’ benefits.

What can the divorce court do with a pension?

The court has three main options.

• Make a pension sharing order (available since 2000).
• Make an attachment order (available since 1997).
• Use offsetting (as discussed above).

The approach to be taken in any given case needs careful consideration, and the author always advises on using the services of pensions advisers to work with clients on what is the right approach in any given financial matrix.

The features of a pension require detailed consideration when assessing the needs of the parties post-separation and the transition to retirement where every pound of pension needs to be shared to make inroads into the provision of post-retirement income to meet need. Many people underestimate the amount of money they need to accumulate to fund an income, post-work, for the remainder of their life.

*Nothing in this article should be construed as the author giving financial advice.