Pension sharing was introduced by Part IV Welfare Reform and Pensions Act 1999 ("the Act") and 16 subsequent sets of regulations and is now available to couples who petition for divorce or nullity of marriage on or after 1st December 2000. Pension sharing is not compulsory and supplements earmarking and offsetting, the existing options for dealing with pension rights on divorce.

Earmarking of pensions on divorce was introduced by s.166 Pensions Act 1995 and applies to divorce proceedings commenced on or after 1st July 1996 in England or 19th August 1996 in Scotland. Earmarking does not affect the circumstances in which benefits are paid under the scheme. It has the effect that once the relevant benefit comes into payment, part of it must be paid to the ex-spouse. Earmarking therefore has the disadvantage that future circumstances, peculiar to the member, may defeat or otherwise affect the rights of the ex-spouse. For example, if the member opts for late retirement, then the ex-spouse's pension would be paid late. If the member were to die before retirement, the ex-spouse would get no pension, although the Trustees could have discretion to pay a lump sum death benefit to the ex-spouse.

Offsetting is the only pre-existing method, prior to the Pensions Act 1995, of dealing with pensions on divorce under the Matrimonial Causes Act 1973, under which an order of a divorce court would not directly affect the pension rights of members of occupational pension schemes, but the value of those rights would be taken into account in the division of other matrimonial assets between the divorcing parties. The size and significance of pension rights today has made offsetting less practicable. There may well in many cases be no other matrimonial assets of sufficient size to reflect the substantial value of the relevant member's pension rights.

The aim of pension sharing is to offer divorcing couples a clean break by allowing the pension rights of the member to be shared between the couple at the time of the divorce. The share that the member's ex-spouse receives is then used to secure a pension for the ex-spouse in their own right.

It is anticipated that pension sharing will be widely relied upon by divorce lawyers and starting from 1st December 2000 trustees will begin to receive requests from members, their spouses and the courts for information that they are required to provide under the Act (which includes valuations of the member's pension rights, the scheme's policy in relation to pension sharing and the scheme's charging policy). Soon after this trustees will start to receive pension sharing orders and it is their responsibility for ensuring compliance with the orders and legislation.

If they have not already done so, trustees of all occupational pension schemes need to urgently review their policies and procedures so that they are ready to comply with the obligations imposed on them by the Act and regulations, otherwise it will be very difficult for them to comply with the time limits set by the legislation.

I set out below the key features of pension sharing, highlighting the key decisions and actions required for trustees and some of the problem areas in the legislation which are coming to light.

2. THE CALCULATION BASIS FOR PENSION SHARING

For the purposes of pension sharing, the value of a member's pension rights is debited by a percentage specified in the court order (in Scotland a monetary value can be specified rather than a percentage) (the pension debit). The ex-spouse then becomes entitled to a pension credit equal to the amount debited, which must then be applied in providing retirement benefits for the ex-spouse.

In general terms the member's pension rights are to be calculated on a cash equivalent basis on the assumption that the member had left service immediately before the effective date of the pension sharing order. A cash equivalent is the ordinary basis of calculation of a transfer value for a member who has left service and wishes to transfer his pension rights out of the scheme to another scheme. The regulations governing the calculation of this cash equivalent value broadly reflect the principles applied in the calculation of transfer payments for withdrawing members entitled to deferred benefits in the scheme.

The actual basis used for the calculation of the pension debit should be in accordance with the recommendations made by the scheme actuary.

Once a pension sharing order has been implemented, the member's cash equivalent transfer value at the effective date of the order will be reduced by the appropriate percentage.

3.    APPLICATION OF THE PENSION CREDIT FOR THE EX-SPOUSE: INTERNAL OR EXTERNAL TRANSFER?

Having calculated the amount of pension credit for the ex-spouse, the trustees must apply the pension credit so as to provide retirement benefits for the ex-spouse. This can be done either:

• via the member's own scheme ("internal transfer"). The ex-spouse's rights are retained in the scheme and the ex-spouse is granted the equivalent of deferred benefits payable from the scheme's normal pension age; or
• via a transfer to the ex-spouse's own pension arrangements ("external transfer"). A transfer payment is made from the scheme to an external pension arrangement i.e. the ex-spouse's existing occupational scheme, personal pension scheme or an appropriate personal pension or stakeholder scheme selected by the ex-spouse.

Trustees have a discretionary power to discharge their liability under the legislation by offering either an internal transfer or an external transfer and will therefore need to make a policy decision on when (if at all) to offer internal transfers (however, if there is a deficit in a defined benefit scheme on the statutory minimum funding requirement ("MFR") basis, they will have to offer an internal transfer).

Trustees must offer an external transfer. It is clear in the legislation that trustees cannot offer an internal transfer if they have not first offered an external transfer. However, if an ex-spouse does not consent to an internal or external transfer (as appropriate) or fails to respond, the legislation gives the trustees a "default option" whereby they may make an internal transfer or an external transfer to a specified arrangement of their choice without consent.

Therefore in practice, the trustees will need to notify the spouse that they can transfer their pension credit to an external arrangement of their choosing (or that they can have internal transfers if they are offering them). They should also notify the spouse what the default option is if they fail to respond. This notification should be carefully worded to avoid future financial services issues and should state that the spouse should seek independent financial advice.

Some schemes have adopted a "hybrid" approach offering internal transfers in certain circumstances, for example, where both parties are members of the Scheme.

Internal transfers and external transfers - policy decision

In reaching their policy decision on whether to offer internal transfers and what the default option should be the Trustees should have regard to the interests of all members and in particular:

3.1 consider the administrative and cost implications of both options;

3.2 consider the potential problems with an external only policy; and

3.3 consider what benefits to offer if they are offering internal transfers.

The trustees will need to record their decisions and keep their policies and procedures under regular review.

1. The cost and administrative implications

The Trustees will need to consider and compare the administration involved in offering internal transfers as opposed to an external transfer only policy. Trustees would normally also consult the scheme actuary. They may also wish to consult the employer although this is not a requirement of the legislation. Issues here include the following:

• external transfers might appear the most straightforward, as the ex-spouse would have no continuing involvement in the scheme. However, provided the ex-spouse is offered the same benefits as deferred pensioners, creating an extra record for the ex-spouse and administering their benefits could be relatively straightforward;
• if an ex-spouse does not wish to transfer out or persistently fails to nominate a receiving scheme, this in itself could generate time consuming correspondence which offering an internal transfer could avoid;
• many arrangements will not accept pension credits without the ex-spouse's consent.
• offering an internal transfer involves creating a class of beneficiaries who have no ongoing connection with the principal employer of the scheme and who may go on to marry, have children and create further beneficiaries who have no ongoing connection with the scheme. This could prove burdensome administratively;
• if an ex-spouse becomes a member of the scheme, they will be deemed to be a member for many purposes, including: the calculation of the levy to be paid to the Pensions Registry; disclosure; access to IDR/the Pensions Ombudsman; discretionary increases and consideration on any distribution of surplus.

2. Potential problems with an external transfer only policy

Fiduciary duties and the external transfer only policy

The main potential problem area is whether trustees owe fiduciary duties to ex-spouses which could be breached if they adopt an external transfer only policy.

It has been suggested that during the period between the pension sharing order being made and it being implemented by the trustees the ex-spouse is a beneficiary of the scheme by virtue of their pension credit. This could mean that the trustees have fiduciary duties towards the ex-spouse, requiring them to have the ex-spouse's best financial interests in mind when deciding whether to discharge their liability via an internal or external transfer. Adopting an external transfer only policy could breach this duty if the benefits from the chosen arrangement are disappointing or because the ex-spouse is not entitled to be considered for possible benefit improvements, as could be the case if an internal transfer was offered.

However, the purpose for which the Trustees are given the power to implement pension sharing orders is to enable an asset of divorcing couples to be divided up on a "clean break" basis and not to provide for ex-spouses' own retirements and for their families on their death. Not all fiduciaries owe the same duties in all circumstances. As long as the Trustees discharge their liability under the legislation by deciding on an internal or external transfer following careful consideration, then they will have exercised the power for the purposes for which it was given (one of the key principles from Edge v Pensions Ombudsman [1999] 4 All ER 546) and will have done all that can be asked of them.

It would also be difficult for an ex-spouse to bring a claim on the basis that he or she was owed a fiduciary duty borne out of the pension trust itself, as it would be difficult to argue that the trust's purpose could be extended this far.

Furthermore, the spirit of the legislation is that schemes should not be obliged to offer internal transfers if they do not wish to.

However, the outcome of these arguments has not been determined by the courts and trustees should be aware of the risk of claims being brought by disappointed ex-spouses if an external transfer only policy is chosen.

Fiduciary duties and the default option

Another concern is that if external transfers are made under the default option with disappointing results, then ex-spouses may bring claims against trustees. Whilst the Trustees may not have a fiduciary duty to offer an internal transfer, it is likely that they do have fiduciary duties in selecting an appropriate vehicle for the external transfer under the default option.

Trustee protection

The best protection in both the above scenarios is obviously to obtain consent from the ex-spouse to the external transfer. However, if consent is not forthcoming then other protective steps would include:

• carefully recording all decisions made concerning internal and external transfers;
• taking investment advice as to the appropriate receiving arrangement. Without the ex-spouse's consent this is probably going to be a deferred annuity as most other arrangements (for example personal pension arrangements) will require the consent of the individual;
• making it clear in all correspondence to the divorcing parties that the default option will be an external transfer and that the Trustees will not be liable for any resulting loss;
• (to the extent permitted by s.31 Pensions Act 1995), excluding the Trustees from liability in the scheme rules;
• making consent to an external transfer one of the pieces of information required to implement the pension sharing order. This could mean that the four-month implementation period would not commence until the Trustees receive the necessary consent to an external transfer.

Whilst these steps may minimise risk, they will not necessarily prevent claims being brought or, whilst the position is still unclear, guarantee protection.

Financial Services Act implications

Concern has been expressed about the Financial Services Act implications of forcing external transfers. The National Association of Pension Funds ("NAPF") has requested confirmation from the Financial Services Authority that there will be no compliance problems arising from the introduction of pension sharing, however, this confirmation is still currently awaited.

3. What Benefits to Offer?

If the Trustees (normally having consulted the employer) do decide to offer internal transfers to all or any categories of ex-spouses, they will need to consider what benefits will be on offer. In particular, would dependants' benefits be paid on death in deferment or in retirement?

Many schemes which have decided to offer internal transfers are offering the same range of benefits available to deferred pensioners on the basis of administrative simplicity, but alternative options (e.g. credits in a separate money purchase section) are available. Again, any policy decision made on this issue should be kept under regular review.

The regulations under the Act do not allow Trustees to provide benefits in return for an internal transfer for an ex-spouse on a defined contribution basis without the ex-spouse`s consent where the member's benefits are defined benefits under the scheme.

4.      INFORMATION AND IMPLEMENTATION

The regulations deal with the provision of information in relation to pension sharing orders and the implementation of the orders in great detail. One specific area in which a policy decision is required, however, is the situation where the ex-spouse dies before the order is implemented.

If the ex-spouse dies after the pension sharing order is made and before it is implemented, the legislation gives the Trustees the ability to choose whether or not to provide death benefits in these circumstances. If they wish to, they can provide nothing in which case the ex-spouse's share becomes an asset of the scheme.

If the Trustees do decide to provide death benefits in these circumstances then they can provide 25% of the pension credit as a lump sum and the usual two-thirds dependant's pension. The Trustees also have the alternative of securing dependants' pensions via an annuity or insurance policy.

The legislation allows schemes to recover their reasonable administration costs (which exclude costs incurred in providing information covered under normal disclosure requirements under the Occupational Pension Schemes (Disclosure of Information) Regulations 1996) from the divorcing couple. Trustees will need to communicate their intention in relation to charges at the outset and therefore must make various policy decisions on how and when they will recover their charges.

Charges may be deducted from the member's accrued rights or pension, deducted from the pension credit, applied as an additional charge on an internal transfer or paid for in cash by the divorcing couple. Key points to note are:

• the Trustees will need to decide whether to make payment of charges a pre-condition of implementation as discussed above. This is perhaps the simplest method from an administrative perspective;
• the Trustees will have to decide what level of costs they can recover. The legislation does not place a limit on charges but does state that they must be reasonable. The NAPF have published a recommended scale of charges. This is an index-linked flat fee in the range of £750 to £1,000, excluding third party costs such as the supply of medical evidence.
• if the pension sharing order apportions the charges between the divorcing couple, trustees should charge them accordingly. If the order is silent, trustees should charge the member;
• if they are recovering costs from the member they need to decide whether they intend to do this by a one-off deduction from the member's benefits; and
• if they are recovering costs from the ex-spouse they need to decide whether they intend to do this by a deduction from the ex-spouse's pension credit.

6.      INLAND REVENUE LIMITS AND REBUILDING OF THE MEMBER'S PENSION BENEFITS

Members whose benefits suffer a pension debit can pay AVCs to increase their accrued pension benefits but, in doing so they will still be subject to the 15% limit on member contributions.

A member's ability to rebuild pension benefits may be restricted, because the shared benefits which are vested in the ex-spouse will normally continue to be considered a part of the member's benefits for Inland Revenue limits purposes. This is subject to the exception that for members whose earnings do not exceed ¼ of the earnings cap during the tax year prior to the divorce, the pension debit can be ignored when calculating the member's maximum pensionable benefits.

7.     ALTERATIONS TO SCHEME RULES

The Act came into force on 1st December 2000. Trustees need to consider what rule changes should be made to implement decisions taken on the issues discussed. Schemes that were approved before 15th May 2000 will have the provisions applied by statutory override for the time being. However, if the rules of the scheme are amended after 1st December 2000, other than for a trivial change, then the Pension Schemes Office of the Inland Revenue will expect the pension sharing provisions to be incorporated into those amendments.

Standard provisions have been prepared by the Pension Schemes Office, however these require tailoring to individual schemes, for example, in relation to the default option chosen by the Trustees and safeguarded rights.

Ideally, the scheme deed and rules should be updated at the earliest possible opportunity to avoid problems when the first pension sharing orders are made.

8.      KEY DECISIONS/ACTIONS REQUIRED NOW

The following are the key decisions that trustees need to make, as soon as possible if they have not already done so:

• Their policy on the internal/external transfers question and, if internal transfers are to be offered, decide on the benefit design.

• What their default option will be and whether they will structure things so as to avoid having to use it.

• What, if any, benefits will be paid on the death of an ex-spouse after the pension sharing order is made but before implementation has been completed.

• Standard notices to be issued at the various stages during the implementation of the order should be prepared in advance together with standard charging schedules.
• What the Trustees are going to charge for, how much and how they wish to recover charges.

Jeremy Harris is a partner in the Human Resources & Pensions Group of dla in Manchester

Editor’s note