When dealing with the pension assets of a divorcing couple received wisdom has always been that where Final Salary (Defined Benefit) pensions were up for grabs, these were the most sought after by both sides since – as the title infers – the benefits were pre-defined and therefore guaranteed to be paid at the level calculated at the time of divorce with inflation proofing thrown in! Lowly Money Purchase (Defined Contribution) pension benefits, however, carried no such guarantees and income was dependent on the performance of the underlying funds and/or the annuity rates prevailing at the time the recipient retires.
The last ten years of credit crunches and unprecedented central bank economic meddling in the form of QE and suppressed interest rates have done nothing to counter this logic – a “no brainer” then!
Well, yes, maybe!
The “Pension Freedom” changes introduced by George Osborne in April 2015 have added a few options into the mix that make the decision a little less straightforward than it might have been before.
To re-cap, the changes were widespread but the ones that are perhaps most pertinent for the purposes of this discussion are as follows
- Income of any level could be withdrawn from the pension fund from age 55 with tax payable at the recipient’s marginal rate of income tax.
- Lump sum death benefits in the form of 100% of the value of the fund could be paid to ANY chosen beneficiary free of all taxes if death occurred prior to age 75. If death occurred after age 75 the benefits would still be free of Inheritance Tax but the recipient would be liable to tax at their marginal rate.
- Provided the funds remained within a pension contract in the hands of the beneficiary then the remaining value could be passed on to their chosen beneficiaries under the same terms as set out above.
So, armed with this knowledge we should perhaps look more closely at the merits of Final Salary over Money Purchase. Let’s assume the following scenario:
- Wife 58, husband 60 and children 30 & 32 who are no longer financially dependent
- Wife has no pension benefits, husband has pension benefits as follows
- £45,000 per annum Final Salary pension payable from age 65 (Cash Equivalent Transfer Value (CETV) £900,000) Tax free cash is available through commutation leading to a reduced initial pension.
- Money Purchase benefit in a Self Invested Personal Pension (SIPP) value £900,000. Benefits are available from age 55 and Tax free cash of 25% of the fund value can be withdrawn (£225,000)
Whilst on the face of it the £900,000 SIPP fund could not initially purchase an equivalent income to the Final Salary scheme via an annuity purchase the Pension Freedom changes throw up some interesting alternatives to the traditional analysis.
Final Salary death benefits in the form of 50% spouses benefits would only be payable to a financially dependent spouse. If the wife takes a pension share but does not remarry or lives with/marries someone independently wealthy then the pension will likely cease on her death. As her children are not financially dependent they would receive nothing. (NB If death occurs within five years of retirement there may be a lump sum in the form of the balance outstanding of 5 years’ worth of pension payments.)
Money Purchase death benefits of the full value of the SIPP fund can be left to any beneficiary regardless of financial dependency. In this case then, assuming wife dies after one year and no income taken or growth on the fund, her two children could each receive £450,000 totally tax free.
Final Salary pension payments are subject to income tax at the recipient’s marginal rate. Once in payment they cannot be stopped or varied. Tax free cash must be drawn at retirement and in one lump sum.
Money Purchase pension payments are also taxable. However, it is possible to withdraw the tax free cash entitlement in stages which could provide a tax efficient income stream.
If we assume inflation at 2% per annum and net investment returns of 5% per annum then, using this strategy, the SIPP could match the Final Salary income net of tax until the wife reached age 99.
Of course should she not reach age 99 then any remaining funds would be available – free of IHT – to her chosen beneficiaries.
Access to Capital
Instead of providing an income, the Money Purchase funds could be used to provide the wife with capital. Obviously a tax-free lump sum of £225,000 could be withdrawn at outset. However, pension freedom rules allow further taxable lump sums to be withdrawn up to the full value of the fund. Whilst this will impact the level of ongoing income available, it introduces an element of flexibility unavailable through Defined Benefit schemes.
Indeed, if other capital is tied up in illiquid assets then the SIPP could provide a non-taxpaying wife with capital of over £610,000 after the deduction of all tax.
In summary then, where flexibility, access to capital and death benefits are a priority, Money Purchase benefits might just have the edge.
The Next Step
If you would like further information on the above post or to discuss your own specific circumstances please give the team a call on 01462 687337 or email email@example.com.
This blog first appeared as an article in Light Blue Law, The Cambridge and District Law Society Newsletter
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