Pension sharing orders and contracting out: key considerations

Until 2016, it was possible to ‘contract out’ of the earnings-related part of the state pension.

This was a key feature of many employers’ occupational pension schemes. The employer and employees paid lower national insurance contributions, with the scheme pension meeting minimum criteria in place of the earnings-related state pension.

The new ‘flat rate’ state pension was introduced when contracting out was abolished and is payable to individuals retiring since 6 April 2016, provided they meet the criteria based on years of national insurance contributions. However, an individual’s contracting out history could still impact the state pension they receive.

A ‘contracted-out deduction’ might be applied to the individual’s state pension to reflect the period that they were contracted out. This will depend on the number of years of full national insurance contributions paid.

In principle, the concept of such a deduction seems fair: the individual paid less into the system and earned a private pension instead.

Pension sharing orders

But a recent case I have been involved with highlighted the lack of understanding of this issue relating to a private pension – in particular when agreeing to a pension sharing order on a divorce or dissolution of a civil partnership.

Pension sharing was introduced in 2000 and aimed at facilitating a “clean break” on divorce.

Pension sharing orders allow a percentage of the value of an individual’s pension to be transferred to their ex-spouse. The ex-spouse is then granted benefits in their own right, either in the scheme or (more often) transferred to another scheme of their choice.

It seems that, in many cases, future entitlement to the state pension is not taken into account when agreeing the terms of a pension sharing order.

In this case, a member of a scheme I advise had agreed to transfer 39% of his pension to his ex-spouse as part of their wider divorce settlement. However, a contracted-out deduction was subsequently applied to his state pension.

This relates to his full period of contracted-out employment, whereas his ex-wife (who was never contracted out) receives a full state pension. Their prospective state pensions were not considered when agreeing the sharing order, but had they been, a different percentage would likely have been agreed.

More information needed

The impact in this case has been compounded by the member’s employer suffering an insolvency between the pension sharing order and his retirement.

His benefits under the scheme have been reduced to Pension Protection Fund levels. This means a 10% reduction to his initial pension but, more significantly, a reduction in the level of annual pension increases. No increases are payable in respect of pension earned prior to 6 April 1997, which is the bulk of his service.

The contracted-out deduction to his state pension increases in line with the Consumer Prices Index, capped at 3% a year, but his remaining scheme pension increases at a lower rate – with most of it not increasing at all. As this compounds over time, the deduction continues to eat into the scheme pension to which it relates.

The member is now pursuing the matter with the Department for Work and Pensions and HM Revenue & Customs.

While there is little the scheme’s trustee can do in this situation, it highlights the importance of divorce lawyers and financial advisers taking state pensions into account when advising on pension sharing orders.

Pension scheme trustees and administrators cannot advise members in relation to a pension sharing order. However, there is a strong case for information packs to be issued in response to notification of a potential sharing order to flag this issue, particularly where the member was previously contracted out through the scheme.     

Michael Collins is a pensions partner at Gateley Legal.