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Pension offsetting: a question for the Family Court, or for an actuary?

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16th February 2016

In ancillary relief litigation, whose responsibility is it to quantify the value of future pension benefits and their non-pension substitutes if offsetting is being considered? What method should be applied to any comparison of pension and non-pension assets?

My summary of WS v WS [2015] EWHC 3941 (Fam), a decision of HHJ Lord Meston QC (sitting as a Deputy High Court judge), who had to consider this very point, has just been published here.

The problem in WS v WS

Neither spouse, after their long marriage, wanted a pension sharing order. Each was a high-earner, and both sought equality of asset division overall, with a clean break.

The pensions had crystallised, and both parties had taken tax-free lump sums:

• H’s defined contribution pension had a CEV of £917k; and
• W’s final salary pension (ie a defined benefit scheme) had a CE value of circa £3.1m. W’s pension was in payment, providing her with £50.6k pa net.

‘[H had] available funds equivalent to cash which he can extract without difficulty. [W had] a guaranteed but non-transferable income stream’ (para [55]).

The parties both believed that a pension share would ‘take the husband well over the lifetime allowance with severe taxation consequences’ (para [46]) (this is doubted by the various experts in ‘WS v WS: Pensions experts’ review‘).

Wife’s approach to offsetting

W assumed that H’s pension would provide income at 2.5% pa, ie 2.% x CEV of £917k. W’s pension was assumed to rise by 2% each year. The total hypothetical income figures of the parties were nominally added together at present, in 12.5 years’ time and in 25 years’ time, to demonstrate the shortfall of H’s income at each point as against W’s. The appropriate Duxbury fund (taking out the state pension) could then be calculated. Three Duxbury figures resulted, being £210k, £324k and £472k. W decided that £400k would be appropriate, and then discounted this for ‘accelerated cash payment’ by 25% to £300,000 (paras [60]-[63]).

Husband’s approach to offsetting

H used various approaches to calculate offsetting (para [64]). Either:

• cash equivalents (CEs) should be equalised, meaning payment by W to H of £1.3m; or
• if H were to buy an annuity to achieve similar inflation-proofed income, he would require £1.2m to equalise incomes; or
• equalisation of CEs after deduction of 40% tax would require payment to H of £750k; or
• if H used his existing funds to buy an inflation-proofed annuity, equalisation of subsequent incomes would require payment of £1.3m.

H also reworked W’s figures with more conservative investment returns, leading to higher Duxbury values of between £438k and £1m (para [65]).

Outcome and critique by the pension expert

The court concluded that there was ‘no obviously right figure or correct calculation’ for offsetting, but ‘[W’s counsel’s] argument for a conventional Duxbury approach is correct, and that is certainly preferable to an annuity-based calculation … the appropriate [offsetting] figure is £425,000′ (paras [71] and [73]).

H was therefore awarded £425k of the non-pension assets as an offsetting figure for W’s extra pension benefits.

In this case, therefore, the High Court had decided that the correct approach to pension offsetting should be based upon Duxbury calculations as opposed to sums required to purchase an annuity to generate an equivalent income to a pension.

Given that equalisation of cash equivalents (which totalled £4m) would have led to H receiving a figure more in the region of £1m, the choice of method had a marked effect on the outcome.

What if a different method were to be used?

In this article, a counter-factual scenario is explored. H is assumed to draw £25k pa net of 40% income tax on the investments. The calculations carried out (and there is even a nice graph!) indicate that the £425k sum would be used up upon his attaining the age of 80, assuming 2.5% investment growth. Were H to have received the larger sum, the payouts would still be continuing were he to live to age 100, and, at the time the ordered sum (the £425k) ran out, he would still have over £1m left in the fund.

The authors of the above article agree with the analysis by Lewis Marks QC in his article for Family Law, ‘An Alternative View of Duxbury: A Reply‘ [2010] Fam Law 614 that a Duxbury fund is designed to provide the current capital value of the income stream it replaces. That income stream – unlike a defined benefit pension – is not guaranteed, and it could of course be terminated: ie it is subject to its own risks. W’s guaranteed benefits pension fund, however, is argued to be ‘underpinned by cautious, low-risk assets in the scheme with the sponsoring employer paying all costs and funding any investment shortfall’. The authors criticise the reliance upon the ‘ambitious returns’ – which go hand-in-hand with the assumptions underlying Duxbury actually being achieved by H: ‘In an uncertain world, why should one party by forced to settle for a return pinned on hope when the other already owns the assets fully underpinned at the current market price?’, they ask. The conclusion they reach is that: ‘Given the theoretical choice of either being the person retaining the pension or the person accepting the Duxbury offer, almost every pension expert would take the pension. This should tell its own story’.

However the article, which states that the viewpoint expressed therein is shared by 13 pension experts, ends on an optimistic note as to the use of an actuary:

‘a pension expert would have corrected the apparent Lifetime Allowance misconception and provided balanced offset calculations that more closely match the true value of the pension assets retained by the wife.’

Of course, the involvement of an actuary was precisely what H had sought at the directions appointment before Parker J. He had been refused an actuary and, furthermore, he had been refused permission by Parker J to appeal that decision.

The fate of the actuary in JS v RS

In JS v RS [2015] EWHC 2921 (Fam) (also summarised by me last year), Sir Peter Singer had had the benefit of an actuarial analysis when considering pension offsetting. The actuary had stated that H would require a pension CEV transfer of circa £248k from W in order to ‘fully match the additional pension income receivable by W’ (para [72]). However, allowing for ‘the greater value (due to immediate access and difference in taxation) generally put on an immediate cash sum’, a figure of circa £210k was suggested (note: such a discount was flatly rejected in WS v WS at para [63], the court being unable to see ‘any justification’ for it).

Was the actuary of assistance in JS v RS? Arguably not. Sir Peter Singer stated:

‘It is at this point that I part company with [the actuary] … [74] I am aware from my general reading that there is at present debate but as yet no conclusion on precisely this topic of appropriately arriving at an offsetting figure.’

Sir Peter concluded, after referring to the amount as ‘necessarily arbitrary’ (para [74]):

‘Offsetting is in this case and in my view by far the preferable and fairer course to take. But I certainly regard a cash payment of over £200,000 as very significantly excessive. Given all the uncertainties which would beset any attempt at principled evaluation I simply take £60,000 as the amount which in all the circumstances of this case W should pay H in order to maintain her pension entitlements intact’ (JS v RS, para 75).

Conclusion

It would be a useful addition to the litigation armoury in financial remedy cases to ensure that an actuary is indeed on board when pension sharing or offsetting is being considered, particularly in light of the fact that the ability to draw tax-free lump sums from pensions in light of the new legislation (Taxation of Pensions Act 2014) changes the very character of what the pension benefit is – it is not just income, but also future capital.

It may be that the case of WS v WS turns on its own peculiar facts – neither party seeking a pension sharing order, and both parties (who were both wealthy) being very close to retirement age. It may be that JS v RS turns on its own peculiar facts – the pension expert was not a joint expert, the funds were not large, there were substantial real property assets (the value of which dwarfed that of the pension fund), and both parties were still young.

However, one must ensure that the actuary is asked the right questions. If offsetting is to be considered, the actuary may wish to know what assets exist with which to offset the pension benefits. What rate of income tax are the parties paying and likely to pay? What assumptions is it reasonable to make about investment returns and risk?

But it is at that last question that the actuary may baulk: the actuary may, of course, answer questions based upon hypothetical investment return rates set out in a letter of instruction, but an actuary is unlikely to prophesy as to the behaviour of the investment markets.

After all, who could have predicted 3 years ago that our petrol prices today would be less than one pound per litre?

Clarity is going to assist, however, and so if each spouse contends that offsetting should be achieved through a different method (given the various approaches set out in ‘Apples and Pears‘, a conference paper by Rhys Taylor and Hilary Woodward (October 2015)) then it needs to be clear in the letter of instruction that there are rival positions with respect to the method of equalisation, so that the court is armed with the full range of options when it comes to make its decision.

And, if you are unhappy with the ultimate decision of the court on pension offsetting in your case, you know what to do, don’t you? That’s right: appeal!

First published by Family Law on 12th February 2015.

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