Pensions, offsetting and methodologies

In July 2019, the Pension Advisory Group (PAG) published its long-awaited report on the treatment of pensions on divorce.

The importance of the report is underlined by President of the Family Division Sir Andrew McFarlane in his foreword: “For too long the division of pension assets, which may often be of significant value, has been confused by jargon, complicated structure and charging provisions: for too long, also, tales of divergent approaches to pension sharing in different court centres have brought the integrity of the system into question… [The guidance] demystifies this area and establishes clear ground rules for the proper approach to be taken in every case”.

A particular issue tackled in the report is offsetting pensions against other assets. As defined in the report, offsetting is “the process by which the right to receive a present or future benefit is traded for present capital or ‘money now’”.

Essentially, one party takes a lesser proportion of non-pension assets in exchange for retaining more of (or all) their pension provision. The report notes that for this to work, there will need to be sufficient other assets against which the pension asset/s can be offset.

There are many reasons why offsetting may be preferable to a pension sharing order. For example, the primary carer may wish to remain in the family home with the children in circumstances where the net equity exceeds 50 per cent of the value of non-pension capital assets.

However, offsetting pensions has caused headaches for practitioners, judges and actuaries for a long time. In particular, there has been much debate as to the appropriate methodology for valuing a pension and calculating the offsetting sum. In the case of WS v WS [2015] EWHC 3941, for example, HHJ Lord Meston QC (sitting as a deputy High Court judge) had to decide between the wife’s Duxbury-based approach and the husband’s annuity-based calculation.

Problems arise because you’re seeking to compare and equate asset classes which are intrinsically different in nature: pension versus cash, property, investments, etc. Of course, the most straight-forward approach to valuing a pension is to refer to its cash equivalent value (CEV) which is an estimate, which scheme providers are obligated to provide in response to form P.

However, CEVs are not often reliable indicators of the true value of the pension benefits, particularly where a party has a defined benefit scheme. Practitioners are advised to tread cautiously in this respect.

The report notes that offsetting pensions without properly considering their value is a growing source of negligence claims against solicitors.

Why CEVs can be unreliable

In their 2015 article, Apples or pears? Pension offsetting on divorce, Taylor and Woodward suggested that the CEV value “occupies an unwarranted totemic position” in the valuation of pension benefits on divorce and neatly articulated its shortcomings as follows:

“The CE [cash equivalent] is the sum one pension arrangement will transfer to an alternative pension agreement to extinguish their liability under the scheme. It is merely a starting point in terms of information.

“While the CE may provide a rough working estimation for standard money purchase / defined contribution schemes, it is often wholly misleading as to the true value of a defined benefit scheme. Different scheme actuaries apply different investment assumptions and therefore the ‘true’ value of defined benefit pensions with similar CEs can be wildly different; further, the ‘true’ value may be significantly higher than the CE.”

So in many cases where offsetting is contemplated, it will be necessary to seek the assistance of a pensions on divorce expert (PODE), usually on a single joint expert (SJE) basis.

The PAG report suggests it may only be sufficient to proceed without and to rely on CEVs for simple defined benefit schemes (with no implicit guarantees, e. guaranteed annuity rates); simply constituted self-invested personal pensions (SIPPs) containing straightforward assets; small pensions; or pensions in big money cases.

Valuation for offsetting purposes

The report is clear that in complex cases where a PODE is involved, the usual approach should be to value the pension holder’s retained present or future benefits, assuming no pension share has been implemented.

This is likely to be the fairest method in most cases given the difficulties in using the CEV mentioned above.

Further, the PODE should consider adopting one of the following valuation methodologies when applying investment assumptions to discount future pension benefits back to a present lump sum (though this is not an exhaustive list):

1. The defined contribution fund equivalent (DCFE) – The gross replacement value of a defined benefit pension and based on an assumption that an annuity would be purchased to match the pension member’s income.
2. Realisable value – What capital would be available if the tax free lump sum has been taken, drawdown has been exercised and tax paid.
3. Actuarial value – Similar to DCFE but with the PODE making certain assumptions to reflect that an annuity is unlikely to be purchased.

The report indicates that these methods are preferable in the offsetting context to fund account value/cash flow modelling or Duxbury-based approaches.

Importantly, the report states that the PODE might usefully set out the calculations for two or three of the methodologies and the perceived advantages and disadvantages of each; and state their preferred option on the facts of the case – though it is not the expert’s role to recommend an answer.

Adjustments for tax and utility

Once an appropriate valuation of the pension has been reached, the value should generally be adjusted to reflect that the pension holder will be taxed on the income received.

The report recommends an adjustment of 15 per cent to 30 per cent depending on the pension holder’s anticipated marginal rate.

These percentages factor in that a pension holder can commonly draw a tax-free lump sum of 25 per cent of the pension’s value. Practitioners acting for the party who is to receive more pension in exchange for capital will often argue that the value ascribed to the pension should be further discounted to reflect the illiquid and inaccessible nature of the asset.

The report concludes that such adjustments will often be inappropriate, particularly in needs cases. Further, utility adjustments are deemed to be a matter for the court as part of its discretionary exercise under section 25 of the Matrimonial Causes Act 1973, and not within the PODE’s remit.

Practice points

The PAG recommends that as a matter of best practice solicitors should record the justification for an offsetting agreement in the D81 in consent order cases.

There may be offsetting cases where it is appropriate to obtain an SJE report, but the client is not convinced that the costs are justified and so chooses not to follow their solicitor’s advice.

In these circumstances, the report says a “prudent lawyer should keep a clear record on the file of the advice given with reasons, signed by the client. Beyond that, how to proceed in these situations is a matter for the advising firm’s internal compliance and risk management procedures”.

The report provides welcome clarity on the circumstances in which a pensions expert report should be obtained in offsetting cases; and the appropriate instructions and remit of such reports.

Given the report’s multiple warnings about the potential for negligence in this area, practitioners might err on the side of caution in determining whether to instruct a PODE – whether as an SJE or a shadow advisor.

Grace Lawrence is an associate at Family Law in Partnership flip.co.uk