When a couple gets divorced then one or both parties’ pensions might be distributed between the couple.
In many cases this is done by the pension owner having a percentage of their pension being deducted from their fund. That percentage is then credited to a pension in the other partner’s name. This is called “pension sharing.”
In other cases the a couple might agree an alternative arrangement called “offsetting.”
Offsetting means the receiving party takes less of the pension owners’ fund. In return, they keep more of the equity in the house or other capital assets, such as savings or investments.
This can be attractive to the receiving party because the money or equity they get to keep is of more immediate use to them.
A pension share, on the other hand, might not be of any use to the receiving party for quite a while. Many pension funds, for example, can only be accessed at 55. Even then, there could be tax penalties to be paid if they wanted to take out money from a pension before a more conventional retirement age of, say, 67 years of age.
Typically, only 25% of a pension fund can be withdrawn tax free. If the remainder of the pension share fund is subsequently relied upon to pay out a monthly pension payment, then income tax might also have to be paid.
Using equity in a property or other savings to offset the receiving party’s pension claim requires careful attention.
Proper consideration has to be given to precisely how much the pension owning party has to pay. It is too simplistic to assume that the payment should be a simple pound for pound trade-off.
For example, if a couple owned a house with £500,000 equity in it and the husband had a pension worth a similar amount, could the non-pension owning spouse say “I’ll keep the house and you keep your pension?”
The couple could agree to do this and many couples do. The agreement is logical on one hand.
The wife is offsetting her potential claim for one half of her husband’s pension – amounting to £250,000 - by keeping hold of his assumed half-interest in the house – also £250,000. One equals and offsets the other.
Let us consider, first, the risk for the paying party.
The pension owning party will likely be paying too much in equity or capital if the potential pension claim is paid off, or offset, pound for pound. It is often possible to agree a discount to reflect the fact that the receiving partner will get certain advantages in having capital rather than the pension funds or to reflect tax savings that they might otherwise benefit from.
A wife, for example, who keeps more of the equity in the family home, is unlikely to have to pay tax on that. Had she taken the pension share then she might have had to pay tax when she withdrew money from the pension fund or possibly pay income tax on the future monthly pension payments that she would receive in her retirement.
Similarly, if the husband is retaining more of his pension then he might have a higher tax liability in the future than he would if he took some capital now.
It is possible, therefore, to discount the capital paid to offset a pension share claim either for the tax that is saved or to compensate the pension owner for the extra tax they might have to pay.
There is another basis for discounting the capital that is paid instead of pension share, and this is called the “utility discount.” This can apply if the receiving party is free to use the capital they retain or receive in any way they want and, critically, whenever they want instead of waiting to age 55 or full retirement age.
The recently released Guide to the Treatment of Pensions on Divorce suggests that the discount that might be applied for tax and utility purposes could be between 20-40% or even higher.
In our example set out above, therefore, the husband might only have to pay his wife with £150,000 of additional capital to offset her claim against, say, £250,000 of pension funds.
Clearly the numbers being used here are for illustration purposes only and the incidence of complicating factors also minimised but the point remains; failing to fully consider the extent of discounts on offset pension claims may lose the paying party money.
Likewise, there could be risks for the receiving party in offsetting agreements. We will discuss this in greater depth in a future article but will summarise the risk here.
The greatest risk is that the receiving party’s wish or need to retain the family home overrides considerations about future income and benefit.
Financial modelling can show how taking more capital up- front results in the receiving party being comparatively worse off in the medium to longer term.
The party who retains the pension, usually combined with a far greater salary, is able to purchase a replacement home and subsequently pay down the mortgage on it. As time passes, they benefit from the full tax-free lump sum from their pension and pension income for the rest of their life.
The party who has retained the house has the short-term benefit but can soon find themselves falling behind their partner in capital and income terms, especially when it comes to retirement age. Whereas the pension holder has secure housing and a guaranteed income for life, the party retaining the home might find they have to downsize to release capital to meet living expenses.