When new pension freedom rules were introduced in April 2015 there was much speculation in the financial press and media that pensions could simply be treated as bank accounts. Whilst this has proved to be an oversimplification in terms of the products available and the tax consequences of large withdrawals, there are some circumstances where the capital value may be more relevant than the potential pension income.
For example, a 50/50 split of the capital value of pensions may now be appropriate in large divorce cases where both (a) there are only money purchase pensions (defined contributions) to consider; and (b) neither party needs to use their pension funds as their main source of lifelong income.
It may be of interest that the younger party would usually need less than 50% of the capital value to achieve parity of income where all of: (i) there are only money purchase pensions; (ii) unisex assumptions are made; and (iii) the parties retire at the same age so the younger party has a longer period during which to invest prior to retirement. This assumes that both parties are in good health.
A common misconception is that the requirement to purchase an annuity from a pension fund was abolished in April 2015, whereas this requirement was actually removed in April 2006. Nonetheless, there has clearly been a significant fall in the proportion of people purchasing annuities following the removal of the limits on income withdrawals and the improvement of pension death benefits that did occur in April 2015.
A 50/50 split of the pension capital value can result in very different outcomes for each divorcing party where there are any defined benefit pensions (eg final salary) or where either party needs to rely on the pensions as the main source of lifelong income.
In broad terms there are only two types of pension schemes; defined benefit pensions (eg final salary schemes) and money purchase pensions (defined contribution schemes).
Defined benefit pensions provide a specific retirement benefit at a normal retirement date. There is no fund allocated or investment risk for the member. In contrast, money purchase pension funds are investments with associated risks and are utilised to generate retirement benefits.
Defined benefit schemes were not affected by the changes introduced on 6 April 2015.
The capital values (CETVs/CEVs/CEs) of defined benefit pensions rarely represent a fair reflection of the value of the pension benefits, in terms of the cost of generating equivalent guaranteed benefits.
Where significant defined benefits are concerned it remains fundamental to obtain a pension sharing/actuarial report or there would be a significant risk of an unfair settlement and destroying the value of the matrimonial assets.
Annuity rates are often utilised in pension sharing reports to facilitate a like for like comparison between each party’s pension benefits post-sharing, where one or both parties are entitled to defined benefits. Defined benefit pensions are often indexed in payment. Annuity rates can provide an indication of the cost of a guaranteed lifelong income, on an objective basis, that takes into account the cost of matching indexation as well as prevailing economic and market factors.
Some feel strongly, even when considering pension income, that utilising annuity rates for pension in divorce calculations is unfair following the introduction of pension freedoms in April 2015. This appears to be based, at least in part, upon an assumption that a higher level of income can usually be generated by other means, if an annuity is not purchased, without any significant risk.
The main alternative to purchasing an annuity is income drawdown.
Depending on personal circumstances and subjective preferences, income drawdown can offer significant advantages where the main objectives include flexibility, passing on funds to relatives or avoiding making an irrevocable decision.
In many cases income drawdown can be appropriate but flexibility does come at the cost of uncertainty, in terms of investment risk, the risk of a falling real term gross annual income in retirement and the risk of outliving the income stream.
Under income drawdown the funds remain invested and the relevant party is able to select the level of gross annual income. There are no annual limits under the new regulations introduced from 6 April 2015.
In the short term, it is possible to generate a higher level of income utilising income drawdown rather than purchasing an annuity.
However in the long term, a higher level of indexed income may not be sustainable and would be subject to investment risk.The suitability of income drawdown depends on prevailing circumstances, preferences and attitude to investment risk. The appropriate level of gross annual income from income drawdown differs between individuals, changes over time and is subjective.
Please note that income drawdown does not guarantee a higher level of lifelong gross annual income compared to purchasing an annuity. Income drawdown might result in a higher level of gross annual income but equally it may lead to lower levels of gross annual income where any of the following occur:
(1) investments fall in value;
(2) the pension funds are held in cash, or in other low risk investments with low returns, because of an aversion to investment risk in retirement;
(3) a low level of income is withdrawn because of concerns of outliving the income stream;
(4) an inappropriate high risk investment strategy is adopted in the hope of achieving high returns to meet unrealistic expectations of sustainable income.
Most pension sharing experts do not recommend taking into account the option of income drawdown indefinitely when calculating fair pension sharing percentages based on parity of sustainable gross annual income.
Assumptions relating to income drawdown are extremely subjective and calculations based on average life expectancy imply an approximate 50/50 chance of the recipient outliving their income stream. As an example, the average life expectancy of a woman age 60 is approximately 29 years. Realistically, are the 50% of women who are expected to live beyond age 89 going to be comfortable investing their pension funds and making complex financial decisions in their nineties? Also, how is it possible to know how much income it is safe to withdraw when the payment period may be, for example, for one year or for forty years?
Purchasing an annuity remains the only method of optimising income payments for someone who wants to maximise their lifetime income without taking risk and ensures that they do not outlive their income.
As such utilising annuity rates, or a broadly equivalent methodology, remains standard practice for pension sharing calculations in expert witness reports regardless of how either party wishes to generate pension benefits.
Please note the presumption of annuity purchase in expert witness reports is only to calculate the pension sharing percentages to achieve a similar outcome for each party, or whatever is required for the case in question. Neither party is obliged to purchase an annuity post pension sharing regardless of the assumptions made in the report. Each party should always seek advice on what is appropriate based on their objectives and circumstances.
Either party with a money purchase pension post-sharing could opt for income drawdown if they are prepared to accept risk in exchange for some other objective such as improved death benefits for their children or short-term goals. However it is important to understand that this cannot be achieved without a degree of investment and longevity risk.
Where the main objective is a guaranteed lifelong income and there is little appetite for investment risk the most appropriate option for many is likely to remain an annuity.The following pension experts agree that the opinions expressed in this article broadly reflect their own views: