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Offsetting is common in divorce and dissolution because the principles are simple. It involves one party keeping an asset that has a value similar to that of one the other party will retain. As pensions are understandably a turn-off, let’s first consider offsetting involving another asset – avoiding the possible detailed arguments and concentrating on the valuation issues.
There are few assets to consider, a joint savings account, a luxury sports car and the ancient run-around they use when it rains. His car is just one of the things over which they argue. Although he ordered it four years ago, he only took delivery last year and he raided their savings account for the £40,000 needed to buy it.
Torquil wants to keep his car, so it is merely a matter of valuing it, the run-around and the savings account. Neither of them wants the run-around so it will be sold. Their savings account has a current balance of £50,000, so the focus is on valuing his car.
The current list price for a new Zola 8 is £41,000, but there is still a three-year waiting list. This has resulted in something of a black market and Zola 8s are allegedly now changing hands for £45,000. Tabatha has found a magazine article in which the founder of Zola Cars bemoans the fact that it costs £35,000 to build the cars, they sell them for £42,000 but one recently changed hands for £50,000.
So what value should be used for offsetting purposes? The list price, replacement cost or some other value? Is there a valid argument for using the £35,000 that the builder says it costs to make the car?
This example has more relevance to pension offsetting than you might think. When dealing with pensions there are similar valuation issues to address, but the answers may not be as simple as they appear. There can be several different values for a pension, the challenge is using one that is appropriate and to do so consistently.
Easiest to value
Potentially the easiest to value are money purchase – defined contribution – pensions. Contributions typically go into an investment fund and it is therefore relatively easy to obtain a value of the fund. For proprietary pensions, the provider will supply a transfer value, which sets out how much will be paid if the pensionholder transfers the pension to another arrangement. In effect, you get this valuation if you request a cash equivalent transfer value (CETV). The question is whether this is the appropriate value to use
There are two main considerations. Some features of the pension are not allowed for in the transfer value. On the other hand, there may be surrender penalties that could be irrelevant for offsetting.
Guaranteed annuity rates featured in a pension are likely to increase its value, as the guaranteed rates will almost certainly be better than those currently available. This will not be allowed for in the transfer value but could effectively increase the value of the asset by 30 per cent or more.
Surrender penalties may apply to the entire pension or just some investment elements. They are often temporary and will rarely apply when the pensionholder retires. As the idea of offsetting is that the pensionholder will keep the pension and it will not be transferred, it is inappropriate to use a transfer value that includes surrender penalties.
Valuing a defined benefit – salary related – pension presents a different set of challenges. Love or hate them, the scheme valuations are an obvious, but inappropriate, option. These have had several different names including cash equivalent transfer values (CETVs), cash equivalent values (CEVs), cash equivalent benefits (CEBs) and cash equivalents (CEs).
CETVs were and sometimes still are what the valuations are called where the member has left service and has the right to transfer the value to another pension arrangement. CEVs are similar but, as the member is still in service and accruing benefits, there is no transfer right. Similarly, if the pension is in payment, there is no right to transfer and the valuations were called CEBs. Since 2008, all valuations are called CEs, though many still use the old names.
How a CE is to be calculated by the scheme is set out in the Occupational Pension Schemes (Transfer Values) (Amendment) Regulations 2000, SI 2008/1050. However, it is wrong to believe this results in a consistent approach between schemes. A CE is effectively the scheme’s best estimate of what it will cost that scheme to provide the members accrued benefits and that best estimate will vary between schemes. Furthermore, there is no obligation on a scheme to value discretionary benefits, which can be significant.
When calculating a CE, it must be done as though the member leaves service on the valuation date. This is particularly relevant for uniformed services pensions that allow early retirement only if members fulfil certain pensionable service requirements; consequently, these valuable benefits are not valued by a scheme CE.
Several public sector pension schemes now offer valuations specifically for divorce purposes and they usually charge for doing them. Whereas, a member is entitled to one free CE (TV) in any 12-month period, providing they have not retired or are within 12 months of retiring. Some divorce specific valuations are calculated as if the member is single and therefore valuable dependant’s benefits are not valued.
It is possible for a defined benefit pension scheme to be in a position where it currently has insufficient funds to cover its current and anticipated pension liabilities. The BA and Post Office pension schemes are two of the higher-profile schemes in this situation. Such schemes can ask their actuary to issue an insufficiency certificate, which then allows the scheme to make an appropriate deduction from the transfer values it quotes. In the past, schemes in this position were said to be underfunded.
If a scheme quotes a value with an insufficiency deduction, the amount of the deduction must be clearly shown. As a schemes’ current funding position does not necessarily mean that it will be unable to meet its future pension promises, there is a strong argument for ignoring it when offsetting.
Valuations done by pension schemes ignore the health of the individual member. This can be an important consideration if the person is in poor health and may have a reduced life expectancy.
As pensions unlike other assets cannot be sold, establishing a true market value can be problematic. Some suggest this can be achieved using what it would cost to buy the same benefits in the commercial pension market. This can lead to some heroic assumptions being made. For example, if a policy has a guaranteed annuity rate on retirement, a value could be placed on that guarantee by comparing the guaranteed rate to the annuity rates currently available, then increasing the value of the pension by the same ratio.
Historically annuity rates have gradually worsened over time, in part because of mortality rate improvements. In other words, it costs more to buy £100 a year of pension now than it did ten years ago, and this trend is expected to continue. If the person who has the pension with a guaranteed annuity rate is several years away from retirement, using current annuity rates as described will undervalue the pension asset.
Using commercial replacement values to value defined benefit pensions is also crude and imprecise. It can be difficult to match the benefits provided by the scheme exactly and discretionary benefits are virtually impossible to mirror. As with the guaranteed annuity rate situation, using currently available commercial annuity rates to value a pension commencing several years in future is likely to undervalue the asset.
The different valuation approaches used by defined benefit pension schemes introduces considerable inconsistency of values. Consequently, comparing pensions using CEs is not comparing like with like.
So what valuations should be used when offsetting pensions? The only fair and appropriate approach is to have the pensions independently valued using a consistent methodology. This would usually mean an independent actuarial valuation, which is not necessarily as expensive as might be assumed. BDM offers a range of appropriate actuarial valuation services. See our website for details, or call us for more information.
Any chance of a discount?
It is often argued that pensions are not the same as other assets because they cannot be turned into immediate cash, and therefore cannot be compared like for like. This can be justification for ‘discounting’ the pension values for offsetting. However, the reasons for using adjusted values can get confused, leading to inconsistencies in the approaches taken. The liquidity argument is reasonable. Given the option of cash now instead of a pension of equal value, some would choose the cash rather than pension. Providing the value of the pension is fair, the degree of the cash need will influence what would be accepted as a reasonable exchange; in other words, the extent of the discount. The greater the need for cash, the higher the discount. If there is no immediate need for cash then there is no justification for a discount. It is not difficult to develop an objective method of quantifying the appropriate discount, but there is certainly no ‘one size fits all’ universal discount.
Another consideration when adjusting pension values for offsetting concerns tax. Pensions enjoy a broadly favourable tax environment compared to most other assets and it is reasonable to take that into account when offsetting as it will not be allowed for in any valuation. In this context, the tax issues to be considered include how the contributions and investments are taxed on one side and how the eventual pension is taxed on the other. Doing the calculations properly means that some information about the financial position of the pensionholder both now and in the future is required. BDM's Pension Offset Reports provide appropriate offsetting discounts using objective measurements to ensure a fair and consistent settlement.
So, that is offsetting. It is not that difficult, but should be done properly.
Peter Moore is managing director of pension valuation specialists Bradshaw Dixon & Moore Ltd. t: 0845 838 2551 www.bradshawdixonmoore.com
This is an adaptation of an article that first appeared in Solicitors Journal www.solicitorsjournal.com