Going through a divorce can be stressful at the best of times, particularly when you’re trying to agree on a financial settlement that suits you both. Emotions can be raw and there’s an understandable desire to get the whole process over with as quickly as possible. So, it’s easy to make impulsive decisions about your financial future.
One area that is often overlooked is pensions – yet they are always included in any divorce settlement. There are a number of different pension schemes and you or your spouse may have more than one type available when you retire.
Types of pension scheme
The amount you receive in your state pension on retirement depends on how much National Insurance you have paid over your working life and any pension credits you receive. A new state pension was introduced in April 2016, with new rules governing how much you receive and the option to pay additional National Insurance contributions to cover years you didn’t work. This means you may receive a pension under both the new and the old schemes. As the rules governing payments and retirement age continue to change, it’s a good idea to monitor exactly what you are entitled to and when on the government gateway.
All companies are legally required to offer their staff access to a workplace pension and in some cases you’ll be automatically enrolled on the company scheme. The government has set minimum contributions that you and/or your employer must pay into these schemes if you’re automatically enrolled into them. The two main types of workplace pension are defined benefit and defined contribution:
1. Defined benefit (or final salary)
In this scheme, you usually pay a set percentage of your wages towards your pension fund and your employer pays the rest. Your pension is linked to – and rises with – your pensionable salary while you’re working. It’s based on your pay up to your scheme retirement date and the number of years you have been in the scheme as a fraction of the years you could have been a member. Your pension entitlement is guaranteed in law and in some cases you can even choose to ‘buy added years’ to increase it.
2. Defined contribution (or money purchase)
The money that you or your employer pay into this type of scheme is invested by a pension provider chosen by your employer. The pension you get when you retire usually depends on how much you’ve paid in and for how long, how much has been taken out in charges, and how well your investment funds have performed.
You can choose to arrange a personal pension plan either yourself, or normally with the help of a professional financial adviser, whether you’re self-employed, employed or even not working. You receive income tax relief on the contributions you pay. This means you can pay a net contribution and your pension provider reclaims basic rate tax relief and adds it to your pot. Alternatively, if you’re self-employed, you pay your contribution gross, offset the contributions against your gross earnings for the tax year and only pay tax on the difference.
Pensions and divorce – a complex issue
With the different types of scheme available and the variety of rules governing them, trying to work out the best deal regarding pensions in any divorce settlement requires expert knowledge. This is why you need an objective advisor who can assess the impact of any potential settlement and help you to achieve the financial security you need, both now and in the future.
To give you an idea of how important independent financial advice might be in helping you make the right decisions about pensions, let’s look at a couple of potential scenarios:
Case 1 – Mr & Mrs Smith
Mr and Mrs Smith’s marriage has broken down and they’re going through a divorce. In terms of assets, they jointly own their own home and have similar amounts of their own savings, which they will keep. However, things are different in terms of their pensions.
Mrs Smith has a final salary (or defined benefit) pension with a cash equivalent transfer value (CETV) of £200,000. Meanwhile, Mr Smith has a defined contribution pension with a CETV of £200,000.
If they take no financial advice
On the face of it, both pensions look the same, as they have similar CETVs. Without financial advice, Mrs Smith says that, as both pensions are the same, she doesn’t want to share them. Mr Smith agrees and this is included in the divorce settlement.
How taking financial advice might change things
As an independent financial advisor, we would look closely at the two pensions to see what the final individual income might be for each partner.
Although their CETV looks the same, they are for different types of pension. This means the CETV is calculated in different ways, so it’s difficult to make a direct comparison.
In defined benefit schemes such as Mrs Smith’s, the CETV may not cover all the benefits. In fact, Mrs Smith’s final salary pension gives her a guaranteed gross annual income, which is guaranteed to rise in line with the Consumer Price Index by 2%-5% per year.
On the other hand, Mr Smith doesn’t have a guaranteed income, as his pension is invested. To achieve an income equivalent to Mrs Smith’s, he would need significant returns, increasing each year to match Mrs Smith’s CPI increases. Taking into account fund management charges, market fluctuations and levels of investment risk, he may find it extremely difficult to achieve the returns he needs to match Mrs Smith’s income. However, his pension does offer him more flexibility. He can access the fund from the age of 55 and take different amounts of income, which he may see as a benefit.
Case 2 – Mr & Mrs Jones
The Joneses are also going through a divorce. They jointly own a house worth £350,000 and each has their own savings of £50,000.
Mr Jones has two defined benefit final salary pension schemes, which combine to guarantee him an annual income of £27,500. He also has two defined contribution pensions with a combined CETV of £315,000.
Mrs Jones has two defined contribution pensions with a combined CETV of £60,000.
In the divorce settlement, Mrs Jones is offered the house and 50% of Mr Jones’ savings.
If they take no financial advice
For Mrs Jones, the prospect of owning her own £350,000 home outright, with another £25,000 in the bank may seem like a good deal. It’s an offer that she may well accept.
However, she has very little pension provision and no guaranteed income, so ignoring the pensions in any agreement could have a detrimental effect on her future finances.
How taking financial advice might change things
With an assumed return of 4% after charges, Mr Jones’ defined contribution pensions would provide him with £12,600 a year, to add to the guaranteed £27,500 from his final salary pensions. So, his annual income would be £40,100.
On the other hand, with the same assumed return of 4% after charges, Mrs Jones could expect to receive an annual income of £2,400 from her defined contribution pensions.
Clearly, this would not be a fair settlement. Talking to a financial advisor would help the Joneses reach a more equitable agreement. For example, splitting the value of the house, all the defined contribution pensions and the final salary pensions equally would greatly increase Mrs Jones’ annual income. She would receive £7,500 from her defined contribution pensions and £13,750 from her final salary pensions, giving her an annual income of £21,250 instead of £2,400. Although Mr jones would have a reduced annual income of £21,250, he would also own half the equity of their property, worth £175,000.
Helping you make the right decision
In any divorce settlement, trying to work through all of the complex factors surrounding pensions on your own without professional financial advice, even with the help of your solicitor, can be extremely stressful. Yet it’s vital for your future income that you understand all the issues involved.
This is why you should take objective advice from an independent financial advisor. Talking it through with someone who understands all these complexities and appreciates your own personal priorities will help you to decide on the most appropriate approach, so you can come to the best agreement possible.