Far-reaching financial consequences of flawed agre
Part 2 of an actuary’s account of problems encountered in deciding how pension rights are to be divided on divorce: drafting the agreement
In my first article which appeared in the April edition, I explained that my experience and that of my colleagues working in the field of pension sharing, had left us concerned about the whole operation of this legislation and the results that can currently be produced.
As I explained, we are not lawyers; we are actuaries and pensions experts. As such, we are seeing an area of great complexity dealt with all too frequently in a simplistic fashion. In a number of cases, this will produce serious untoward, and probably unexpected, financial effects.
In the first of these two articles, I looked at the problems encountered in getting the information and then arriving at a decision as to how the pension rights should be taken into account. In this article, I will examine the problems that arise in the final stages – drafting the order/agreement and implementation. In particular, I will look at the specific problems that exist in Scotland because of the requirement in the legislation to draw up the matrimonial assets at a date in the past, typically the date of separation, whereas the share cannot be actioned until after the divorce.
The Importance of the Relevant Date
The existence of a Relevant Date at which the assets are valued is a feature of Scottish matrimonial law, which also applies in Northern Ireland, but which does not apply in England and Wales. Matrimonial law is an area of law devolved to the Scottish Parliament, but pensions law is not. Pension Sharing was developed in Whitehall in the context of English matrimonial law, and insufficient account has been taken of the problems arising because of critical differences in matrimonial law in the other legislatures of the UK.
There are two categories of issues that arise because of the use of the Relevant Date:
- The financial effects of the time lapse; and
- The changed situation of the scheme member or the scheme.
These problems do exist also in England and Wales, but only to a much lesser extent. In Scotland, the use of the Relevant Date amplifies these problems to such an extent that to ignore them can lead to unfortunate and sometimes ridiculous results. As an example of this, we have been involved in a case in which a husband intended to share 50% of his pension at the Relevant Date. Had the lawyer not involved us, the actual result would have been to leave him with no pension whatsoever, since the value of the pension rights at the date of divorce was less than half the value at the Relevant Date!
The Financial Effect of the Relevant Date Issue
What should be happening?
Matrimonial property is valued as at the Relevant Date. That is accepted practice. It is then divided fairly, usually equally, between the parties. Any increase or decrease in the value of any particular asset between the Relevant Date and the date the asset is transferred will not be taken into account when determining what amounts to fair sharing. This issue has frequently been addressed, particularly in relation to matrimonial homes.
It is essential that, for consistency, this same approach of valuation as at the Relevant Date and subsequent fair division at the time the asset is transferred should be applied to pension rights.
The legislation lays down clearly how the pension rights belonging to each party should be valued as at the Relevant Date, and that value is commonly referred to as the CETV. However it is very important to realise that the asset is actually the pension rights, typically expressed as an amount of pension or lump sum, and that the CETV is the value of those assets. It is vital to appreciate the difference between these concepts. The CETV itself is not the asset.
At first sight what should be done appears to be straightforward. All that seems to be necessary is a simple process:
- The amount of the CETV to be shared at the Relevant Date should be determined;
- An instruction should then be sent to the pension scheme to implement this, either as a stated amount or as a percentage.
Unfortunately, this does not produce the results intended by the legislators.
Why is this happening?
The pension scheme can only carry out the pension share as a transaction on the current value of the pension rights. But the lawyer has determined the amount to be shared based on an old value of the pension rights calculated as at the Relevant Date, an old CETV at a date in the past.
It is an absolute rule of finance that monetary values at different dates are effectively different currencies. The pension scheme is effectively being asked by the lawyer to subtract that amount to be shared, calculated from the old CETV from the pension scheme’s current CETV to create a pension share now. Mathematically and financially, this is a nonsensical request and can often lead to bizarre results.
Transferring pension rights is not like transferring saleable assets. When the pension scheme receives an instruction to carry out a pension share, it will carry this out in strict arithmetical terms. It does not normally look at the significance of the instruction. A pension sharing instruction from Scotland looks similar to a pension sharing instruction from England, and the only objective of the scheme administrator is to ensure that the benefits set up for each of the parties reflect that instruction in mathematical terms, regardless of its wider significance.
Because the pension scheme is being asked to carry out a transaction that is intrinsically unsound, the result of this transaction will also be unsound. The actual effect is that the resulting pension share will unavoidably take account of at least some of the changes that have occurred since the Relevant Date, because of the use of the current CETV by the pension scheme administrator in part of the calculation. This is exactly contrary to what the lawyer is trying to achieve.
What is the effect?
The pension scheme receives an instruction to implement the pension share, either as a stated amount or as a percentage. Because of the impact on the calculations caused by the scheme administrator using a current CETV, both these options produce results that can be bizarre, and in fact wrong, although, interestingly, different to each other:
- a) If a percentage is used, this has been derived from the old CETV, but the scheme must apply it as a percentage of the current CETV. This clearly gives the spouse a share based on current values rather than those as at the Relevant Date.
This is against the principle that any increase or decrease in the value will not be taken into account when determining what amounts to fair sharing.
- b) If a monetary sum is used (derived from the old CETV), the scheme will deduct this from the current CETV. This is financially unsound. The net effect is that the amount of the pension rights that will be secured for the spouse that is almost a random number, and is certainly neither the value as at the Relevant Date nor the current value. It is not a logically derived figure, and is, in fact, meaningless.
The case referred to above fell into this category. In that case, the husband had a personal pension valued at £140,000 as at the Relevant Date, and it had been agreed that 50% of this was to be shared. This was described as a share of a monetary sum of £70,000.
Unfortunately, by the time of implementation, falling stock market values had reduced the value of the pension to £51,000. To implement the share would have given everything to the wife and left the husband with nothing at all.
Indeed, it could be argued that in this case the husband was lucky that the value had fallen so far. Had it fallen only to £71,000, then the scheme might well have proceeded to implement the share, and no problem would have been seen until the husband had received his first statement confirming the outcome of the share, by which time it would have been too late! In fact, some insurers will implement requests like this without question, leaving the member with nothing.
What is the answer?
The underlying principle must still be to use the value as at the Relevant Date, as required by the legislation, and then divide fairly, as at the Relevant Date, between the parties, so that any change in the value between the Relevant Date and the date of transfer does not affect the intended effect of the share. Basically, the effect of the share should be to put both parties in the position they would have been in had the pension share been effected at the Relevant Date. By this I mean that the pension rights which it was agreed should be shared should not change.
The answer to the problem lies in careful drafting of the agreement or order to ensure that this result is achieved.
How is this achieved?
At the time a Separation Agreement is written, the intention of the pension share should be clear. It may well not be possible, however, to specify exactly how it will be implemented, as the actual result will depend on the date at which the share is put into effect, and critically on financial conditions at that time.
Accordingly, the Separation Agreement should specify exactly what the intention is, and should contain provisions committing both parties to entering a Qualifying Agreement shortly before divorce (or not opposing a court order). It would be this Qualifying Agreement (or court order) that would be sent to the pension scheme for implementation. This is the sole purpose of the Qualifying Agreement.
The pension scheme will only want to know the amount or percentage being shared as at the date the share is put into effect. The scheme administrators will not normally be interested in a long story about what the couple are trying to achieve.
Changes since the Relevant Date
What changes can occur?
In Scotland, there can be an interval of several years between the Relevant Date at which the value being put into Matrimonial Property is assessed, and the date at which a pension share is put into effect. This was not properly considered by the legislators at the time the legislation was developed. The pension scheme is a moving target, not just with regard to the value, but also in respect of what state the benefits will be in.
During this interval there can be many changes in the status of both the member and the pension scheme itself. The member might leave the pension scheme or retire. He might get a promotion. Additionally, either party might die between the time of the Separation Agreement and the implementation of the pension share. On the other hand, the change could be completely outwith the control of either of the parties. The pension scheme might close. Its benefit structure might be altered significantly. Its funding level might be affected by stock market changes – a particularly relevant issue at the moment.
These changes can have a major effect on the pension rights arising from a pension share, and any agreement between the parties must be drawn in such a way as to deal with these contingencies. In some cases, it may be possible to be specific as to what should be done in these eventualities. In other cases, an arbitration clause might well be appropriate.
The list of possibilities as to changes that might occur is very long indeed. I will concentrate on some of the most critical. It is very important that any agreement between the parties takes these possible circumstances into account. Leaving
The scheme member might change employment. As a consequence his benefits in the scheme could move into a preserved state, or alternatively they may be moved to another scheme, possibly of a very different type. Indeed this latter possibility can happen even without a change of employment.
The effects of this can be very varied indeed. The main point is that the pension share that was proposed at the time of the agreement may now look very different, with radically different consequences for the member’s spouse.
What would happen if the scheme member retired between the Relevant Date and the date of transfer? The retiring member will almost certainly take advantage of the option (or the right) to take a tax-free lump sum in lieu of some of the pension. This has three main effects. Firstly, the retirement lump sum can only be taken once, so that after the share, his spouse will not be able to take advantage of this benefit, something she may well have been relying on. Secondly, all the pension rights will be fully taxable rather than a portion being received tax free in the form of a lump sum. Thirdly, the CETV of the remaining benefits will be significantly reduced. Indeed, they will be further reduced if a significant time lapse occurs and a number of pension payments are taken.
If the scheme member is an active member of a defined benefits pension scheme, he will be accruing more rights with each day’s service. There will also be a sudden and significant increase in his CETV on obtaining a salary rise. The net effect is that it is normally impossible to predict what such pension rights will be worth in a few years. Accordingly any decision to share a percentage of rights will automatically be giving the benefit of these changes, which occurred after the Relevant Date, as part of the share.
Death of either party
An agreement might be drawn up in which the pension share was essentially the balancing item. If the scheme member dies, there will be no pension rights to share. There is not even certainty as to whom the spouse’s pension will be paid. Many schemes these days will pay this to the partner at the date of death, particularly if there are children. A separated wife can have no certainty, as what the scheme will do depends on its rules at the date the member dies. Lump sums will virtually always be paid at the discretion of the trustees and the spouse of the member certainly cannot rely on that as a guaranteed source for settlement.
Conversely, if the spouse of the scheme member dies, that party may have accepted significantly less of the marital assets in the expectation of the pension. As this will never have been implemented, then the estate of this party will have lost out.
Changes in the pension scheme
This is the most complex area of all, and the area where real damage can be done to either party by a carelessly worded agreement. The following is not an exhaustive list:
- Closure of scheme;
- Change in benefit structure of scheme;
- Alteration in funding level of scheme;
- Introduction or removal of discretionary benefits.
It is very important to realise that each of the parties to the pension share will have expectations, probably rather simple expectations, as to what the effect of the share will be. Any of these changes can have a radical effect on the outcome for one or both parties.
The regulators of the financial services world have consistently taken the view that an expectation created in an individual should be achieved. They certainly expect individuals to be fully informed and to be given a clear understanding of the nature of the transaction they are undertaking, what the possible results are, and what the risks are. The fact that there is no clear regulation of pension sharing transactions at present should not be a source of comfort, as retrospective action has become a feature of financial services regulation in recent years.
In these two articles, I have shown the types of problem that can arise when implementing a pension share. It is a subject that can look deceptively simple, and the actual administrative processes are not difficult.
The difficulty arises because of the nature of pension rights, which are very different from any of the other matrimonial assets. It is only too easy to follow all the procedures, and carry out a pension share in what looks like a common-sense fashion, only to find that the financial consequences are far removed from either what was intended or what the parties to the share expected.
Many family lawyers simply do not appreciate the significant problems involved with pension rights, and, as a result, are failing to deal with pension rights on divorce in the best interests of their clients. It is essential to think through the consequences of what is being implemented, as these consequences can be very significant indeed.
What then should the family lawyer do? As I stated in the first article, the golden rule must be to determine what the actual result of the pension share will be for the two parties involved, and then to ensure they are made fully aware of this. This must be in terms of pensions payable, for ultimately that is what matters in practice. Any decision made by the client must be with full knowledge of the effects of that decision. That must be the responsibility of the family lawyer. If in doubt, seek professional advice.