Calculating pension offsetting.
Offsetting pension entitlement against other assets is very common in divorce settlements, but it is difficult to get it right.
There is no legal definition of “pension offsetting” but for many divorcing couples it appears to be an obvious option. Person A and person B (to be entirely gender neutral) have a house, some savings, and various pensions – B has more pension than A. It seems obvious that A should get more equity from the house, to make up for B’s better pension. Lawyers call this pension offsetting, and it is very common.
But how do you work it out fairly?
First, let me stop you there. Ask yourself seriously - is offsetting the best thing to do? When you have read this post you will appreciate that there is no answer to how to calculate a pension offset fairly. So although it seems like a simple idea in theory, in practice whatever number you come up with will be unfair. The natural alternative to offsetting is to a pension sharing order which will divide the pensions between you as a separate exercise from dividing the equity in your home and any other savings. Judges understand this point, and if they have to make a decision they will generally avoid offsetting and go to pension sharing if that is an option.
Pension sharing orders produce a fairer result than pension offsetting. People are put off pension sharing, because it seems complicated, they are told that the pension scheme would charge huge fees and it may involve an actuary’s report which will be very expensive. That is mostly myth – pension sharing is not particularly complicated and need not be expensive. Most pension schemes charge nothing to provide the information you need for a pension sharing order, and nothing or very little to put it into effect. Think in the region £1,000-£2,000 for an actuary’s report. For that A and B would get a detailed analysis of their pension arrangements, clear advice about how to divide them fairly, and the comfort of knowing that they have not missed anything or made any mistakes. Put that way I think it is good value. They would routinely spend several times that amount on estate agent’s fees to sell their house. Granted, the actuary’s fee has to be paid in cash which A and B have to find, whereas the estate agent’s fee is skimmed off the top of the value of the house you sell it. Even so, actuary fees are quite good value. To become an actuary you have to be exceptionally bright and it takes years of training.
If you are still determined to do offsetting you will ask your solicitor to advise you on a fair number – “how much extra equity from the house should I have in return for say £100,000 of pension?” At this point you will see them going into reverse and becoming rather vague. The answer is “something less than £100,000” but nothing more definite than that. Often they start talking about “apples and pears”. Helpful if you want advice about a healthy diet, not much use if you want advice about your pension.
That is because there is no answer to the question. In the end it is a matter of personal opinion. But let me offer some guidance to help you through the maze.
The CE (“cash equivalent”) value may seem like the obvious place to start. You can get the figure from the pension scheme relatively easily, and for a simple defined contribution scheme it probably is a useful and logical starting point. But watch out for snags, such as guaranteed annuity rates and deferred benefit underpins such as GMP (“guaranteed minimum pension” ) in which case the CE value is probably not the place to start; and for a defined benefit scheme the CE value is almost certainly not the place to start.
Where do you go from there? As with most explanations about pensions, it is best to start by looking at a defined contribution scheme. In that case a CE value of £100,000 means (roughly) that the scheme is holding £100,000 of investments on behalf of the policyholder. You need to make two adjustments.
The first adjustment is for tax. If person A has £100,000 of equity in a house they can sell the house and have the money tax-free. Whereas if person B has £100,000 in a pension scheme, they will have to pay tax as they take the money out. B should be able to take 25% tax-free, and the tax paid on the rest will depend on whether B is a basic rate or higher rate taxpayer. It is generally agreed that you should deduct something in the region 15% to 30% depending on where B stands on that spectrum.
The second adjustment is for the benefit of having cash now rather than cash later. Lawyers call this the adjustment for “utility” and it is entirely subjective. Factors which might come into play include how far off retirement you are, and how desperately you need cash or equity now. Sometimes there is no perceived benefit in having cash now, for example if A is quite close to retirement age they might actually prefer to have a stake in say the Civil Service Pension Scheme rather than a bit of extra cash in the bank. It is generally agreed that the adjustment for utility should be in the range 0% to 25%.
The explanation is more complicated when you turn to defined benefit schemes because it is harder to find a starting point. The basic problem is that the CE value is almost certainly not the logical place to start. For example, if B is told that under the NHS pension scheme they are entitled to a pension of £20,000 per annum, and it has a CE (“cash equivalent”) value of £750,000, that does not mean the NHS pension scheme administrators are holding £750,000 of investments on behalf of B, and £375,000 is not the starting point for offsetting. The better way to approach it is to ask what it would cost B replace the £10,000 per annum pension B might lose if a pension sharing order were made. That is a difficult question to answer and almost inevitably A and B would have to ask an actuary. In my view you should always involve an actuary if you are looking at a defined benefit scheme with the CE value of about £100,000 or more. But if you are looking at a smaller scheme than that, or just want to get some idea, you will find useful materials on the government’s money advice service website (www.moneyadviceservice.org.uk).
I hope you have found the information in this post helpful, you can find more about pensions in divorce generally on the main website. But there is no substitute for obtaining expert advice about your own situation. The information in this post is correct, and up-to-date as at November 2020, but I can accept no responsibility for any loss you might suffer as a result of relying on it without obtaining your own professional advice.
John Pratley is an expert divorce lawyer, who has more than 25 years experience advising clients purely about divorce and related family law issues, such as the financial consequences of separating and divorcing. After establishing the first niche family law practice in Bristol, and going on to senior management roles in a national firm, John set up Apple Tree Family Law in 2018. Apple tree family Law solicitors specialise in advice about divorce and financial issues.
We are based in Bristol and Exeter, but we have clients all over the UK and further afield. We offer, simply, clear and accurate advice about divorce and family law issues, and the very best client service, for a clear and reasonable price.