Divorce and Financial Impact on Retirement

Divorce can be a financially complex and emotionally challenging process. Beyond the immediate division of property, assets, and savings, one of the most significant concerns during a divorce is the impact on long-term financial security—particularly with regard to pensions. In the UK, pensions are often one of the largest marital assets, making their division during a divorce crucial for both parties’ future retirement planning.

A Pension Sharing Order (PSO) is one of the most effective methods for ensuring a fair division, but it requires careful planning, expert financial advice, and legal support to navigate successfully. In this blog, we will explore the intricacies of pension sharing orders, alternatives to pension division, and the indispensable role of retirement planning during divorce.

What is a Pension Sharing Order?

A Pension Sharing Order (PSO) is a legal tool used during divorce to divide pension assets between the two parties. Unlike other options like pension earmarking or offsetting, a PSO ensures that both parties receive their own independent pension pots after the divorce, allowing each spouse full control over their pension contributions and retirement planning. The court issues a PSO, and the pension scheme is then required to implement the division by transferring pension credits to the non-pension-holding spouse, either into a new or existing pension scheme.

Key features of a PSO:

•   Clean Break: Once the pension is divided, each party manages their pension independently.
•   Flexibility: The pension credit recipient can decide how to invest their share, tailoring it to their retirement needs.
•   Types of Pensions Eligible for PSOs: Most workplace pensions, private pensions, and the additional state pension (for those on the old state pension system) can be divided, but state pensions themselves are generally exempt.

The Role of an Independent Financial Adviser (IFA) in Pension Sharing

Navigating pension division during a divorce requires more than just legal advice—it demands financial expertise to ensure both parties receive a fair share and have a sustainable retirement plan post-divorce. This is where an independent financial adviser (IFA) becomes indispensable:

1. Comprehensive Financial Analysis

An IFA will provide a complete overview of both parties' financial assets, including pensions, investments, and savings. This detailed analysis ensures a transparent division of assets, ensuring that each spouse understands the long-term impact of the pension split.

2. Tailored Retirement Planning

For many, divorce disrupts carefully laid retirement plans. An IFA helps assess how the pension division affects each person’s long-term financial security. They assist with recalibrating retirement goals, adjusting pension contributions, and setting new investment strategies.

3. Collaboration with Legal Teams

While an IFA does not offer legal advice, they work closely with solicitors to ensure all financial aspects, particularly pensions, are correctly accounted for. They can help determine the Cash Equivalent Transfer Value (CETV), which is essential in determining how much of the pension can be shared.

Pension Offsetting and Other Alternatives

While a Pension Sharing Order (PSO) is a common method of dividing pension assets during divorce, it’s not the only option. Couples may also consider alternatives like pension offsetting or pension earmarking, each with its own set of pros and cons.

Pension Offsetting

Pension offsetting allows one spouse to retain the pension in exchange for other assets, such as a larger share of the family home. This method provides flexibility and avoids having to divide the pension itself. However, it requires an accurate valuation of the pension, and issues may arise if the pension’s value changes significantly over time.

•   Advantages: Immediate access to other assets, such as property or savings.
•   Drawbacks: Risks undervaluing the long-term significance of pensions, which may be more valuable than initially estimated.

Pension Earmarking (Attachment Orders)

With pension earmarking, one spouse receives a portion of the pension income when the other begins drawing their pension. While it ensures that the receiving spouse benefits from the pension, earmarking lacks the "clean break" that a pension share order offers.

•   Advantages: A simpler option for those who want to wait for the pension-holding spouse to retire.
•   Drawbacks: No control over when the pension is paid out, and payments may cease if the pension-holding spouse dies or remarries.

Deciding between these options depends on your unique circumstances, and it’s crucial to work with both your legal team and an independent financial adviser (IFA) to ensure the right choice is made for your long-term financial security.

The Process of Implementing a Pension Sharing Order (PSO)

The implementation of a Pension Sharing Order (PSO) is a multi-step process that involves both legal and financial professionals to ensure the accurate and fair division of pension assets during divorce. Due to the complexity of the process, it is important to be familiar with each stage, from obtaining court approval to dealing with costs and fees.

1. Obtaining a Court Order

The first step in executing a Pension Sharing Order is obtaining the court’s approval. A PSO is part of the financial settlement agreed upon during divorce proceedings. It legally outlines the percentage of the pension that will be transferred from one spouse to the other. Both parties, along with their solicitors, will present evidence to support their financial positions, and the court will decide how to divide the pension assets. The PSO ensures that once the divorce is finalized, each spouse has independent control over their portion of the pension.

2. Cash Equivalent Transfer Value (CETV)

The Cash Equivalent Transfer Value (CETV) is the financial value assigned to the pension at the time of the PSO. It represents the amount that will be transferred to the other spouse. Determining the CETV is a critical step, as it forms the basis for dividing the pension. It is essential to ensure the valuation accurately reflects the current market value of the pension, particularly for defined benefit pensions where the CETV may not capture the true long-term value. A financial adviser or pension expert is often needed to accurately determine the CETV.

3. Transfer Process

Once the court issues the Pension Sharing Order, the pension provider must begin the process of transferring the pension credits to the receiving spouse. The pension provider is legally obligated to follow the PSO and must adhere to specific timeframes to implement the transfer.

•   Transfer Timelines: Typically, the pension provider has a deadline—often up to four months—to complete the transfer. However, this timeline may vary based on the complexity of the pension and the provider’s internal processes.
•   New Pension Scheme: If the receiving spouse doesn’t have an existing pension scheme, they may need to set up a new one to receive the pension credits. The transfer may go into a personal pension or into another pension scheme of the spouse’s choice.

The complexity of this step can vary depending on whether the pension is a defined contribution or defined benefit pension. Defined benefit pensions, in particular, can present challenges due to their long-term payout structures, making the transfer process longer and more complicated.

4. Costs and Fees

Implementing a Pension Sharing Order incurs various costs. Both parties should be aware of these fees to ensure they can budget accordingly:

•   Court Fees: These are the costs associated with filing the PSO with the court, and they vary depending on the complexity of the divorce settlement. Typically, court fees in the UK can range from around £255 to £1,000 depending on the scope of the financial order.
•   Solicitor and Legal Fees: Both parties will need legal representation to negotiate and finalize the PSO. Solicitor fees depend on the complexity of the case but can run into several thousand pounds if disputes arise regarding the pension valuation.
•   Pension Scheme Administration Fees: The pension provider may charge an administration fee to process the pension division. This fee covers the internal costs of valuing the pension, implementing the transfer, and setting up new pension arrangements for the receiving spouse. Administration fees can range from £500 to £3,000 depending on the provider and the complexity of the pension.

5. Adjusting Retirement Plans

Once the pension has been divided and the transfer completed, both spouses will need to reassess their retirement planning. The division of a pension can significantly impact retirement goals, especially if one spouse was heavily reliant on the pension income. Both parties should consult with an independent financial adviser (IFA) to develop new retirement strategies that account for their revised pension pots, adjusted contributions, and updated investment strategies.

It’s crucial to understand that the transferred portion may perform differently based on the new investment options or schemes selected by the receiving spouse. Professional financial guidance ensures that the pension division supports both spouses' long-term financial well-being post-divorce.

Complexities of Pension Types in Divorce

Not all pensions are equal in terms of value and ease of division. During divorce, understanding the type of pension being divided is crucial, as some pensions are more complex than others.

Defined Benefit vs. Defined Contribution Pensions

•   Defined Benefit Pensions: These pensions promise a guaranteed income in retirement, making their value harder to calculate. The CETV may not reflect the true value of the long-term income provided.
•   Defined Contribution Pensions: Easier to divide as they are based on accumulated contributions, these pensions provide more flexibility in terms of transferring and managing the split.

State Pension Considerations

While the basic state pension cannot be shared, additional state pensions (such as SERPS) can be divided during divorce. However, it’s important to understand the limitations and which parts of the state pension may be relevant in your case.

Key Considerations for Pension Sharing Orders

1. Tax Implications

The transfer of pension assets through a pension sharing order can trigger tax implications, particularly for the receiving spouse. One of the major concerns is the impact on the lifetime allowance—the total amount of pension savings an individual can accumulate without incurring tax penalties. As of the 2023/24 tax year, the lifetime allowance is set at £1.073 million, though any pension assets exceeding this threshold may be subject to significant tax charges of up to 55% for lump sum withdrawals or 25% for pension income.

An independent financial adviser (IFA) plays a crucial role in structuring the pension transfer to avoid breaching the lifetime allowance. They can help assess how much of the pension can be safely transferred without exceeding the limit, while also ensuring the transfer aligns with both parties’ long-term financial goals. This is particularly important for high-net-worth individuals or those with substantial pension pots nearing the limit.

•   Pension Transfer Timing: The timing of the transfer can affect tax liability, especially if market conditions cause pension values to fluctuate.
•   Tax-Efficient Withdrawal Strategies: An IFA can also recommend strategies to withdraw pension income tax-efficiently, thereby minimizing unnecessary tax burdens post-divorce.

2. Pension Valuation Fluctuations

Pension valuations are subject to market conditions, which means the Cash Equivalent Transfer Value (CETV) can change between the time of the court order and the implementation of the PSO. For example, a pension invested heavily in equities might see significant fluctuations based on market performance, leading to a discrepancy between the CETV at the time of valuation and when the transfer is completed.

It’s crucial to keep in mind the following:

•   Market Sensitivity: Defined contribution pensions, which rely on investment growth, are more vulnerable to market volatility. A falling market might lower the value of the pension, whereas a rising market could increase its value.
•   Defined Benefit Schemes: These pensions often use formulas to calculate benefits based on salary and years of service, but the CETV might not always reflect the true future value of guaranteed benefits. It’s important to have a financial expert assess whether the CETV offers a fair representation of the pension’s worth.
•   Professional Guidance: Solicitors and IFAs work together to ensure that pension valuations are up-to-date and accurate at the point of transfer. This collaboration helps mitigate the risk of unfair divisions due to valuation discrepancies caused by market movements.

By engaging both legal and financial professionals, divorcing couples can navigate these fluctuations, ensuring the division remains as fair and equitable as possible.

3. Impact on Retirement Plans

Divorce represents a significant shift in financial circumstances for both parties, particularly when it involves the division of pensions. Post-divorce, it’s essential for both spouses to reassess and revise their retirement plans. Splitting a pension often results in smaller retirement pots for both parties, which necessitates adjustments to contributions, savings, and investment strategies.

•   Adjusting Pension Contributions: After a pension is divided, both parties may need to increase their contributions to rebuild their retirement savings. This can be especially important if either party is nearing retirement age and has limited time to grow their pension pot before they stop working.
•   Recalibrating Investment Strategies: The receiving spouse, particularly if they are younger, may choose to adopt a more aggressive investment strategy to make up for the smaller pension value they received. On the other hand, older individuals may prefer a more conservative approach to preserve their pension savings.
•  In come Projections: After the pension split, both parties should revisit their income projections for retirement. With the division of assets, one or both parties might need to consider alternative sources of retirement income, such as downsizing, delaying retirement, or supplementing income through part-time work.

Incorporating the changes in pension value and retirement income into a revised financial plan is crucial to ensuring that both parties can maintain their desired lifestyle post-retirement. Seeking advice from an independent financial adviser can help each individual reestablish a solid retirement strategy that accounts for the division of assets and maximizes the potential for financial stability in the years ahead.

The Emotional and Practical Benefits of Pension Sharing

Choosing a Pension Sharing Order offers both emotional and practical benefits:

• Emotional Benefits: A PSO provides a "clean break" for divorcing couples, removing the need for future financial dependency or entanglements. This is particularly important for those who wish to move forward with their lives independently.
• Practical Benefits: Once the pension is divided, each party can manage their own retirement savings, investments, and withdrawals. This flexibility allows each spouse to tailor their financial planning to their individual needs and goals.

The Role of Expert Advice in Pension Sharing and Divorce

Divorce complicates financial planning, particularly when it comes to divorce and pension sharing. A Pension Sharing Order ensures that both parties can secure financial independence while planning for their future retirement. However, the complexity of pension division demands expert advice. Working with both a legal team and an independent financial adviser (IFA) ensures that the process is handled smoothly, fairly, and with the long-term financial well-being of both parties in mind.