Over the course of 2022 we have seen interest rates rise from their historical lows of 0.1% to 2.25%. There is every expectation that rates will rise further over coming months, and by the end of 2023 rates could be around 4% – a level not seen since the global financial crisis in 2008.
So how might interest rate rises affect clients where pensions are being shared as part of the divorce settlement?
Rate rises have affected the transfer values of pensions
Splitting pensions fairly on divorce can be challenging, especially if there is a defined benefit (DB), sometimes called “final salary” or “career average”, pension involved.
The recent Bank of England rate rises have had an impact not only on mortgages and borrowing, but the rate rises have also indirectly had a major impact on the Cash Equivalent Transfer Values (CETVs) offered by DB pension trustees.
This is because CETVs (in simplistic terms) are underpinned by UK government bonds, known as “gilts”. 2022 has seen some dramatic moves in the gilt market.
Fundamentally, the CETV for a DB pension scheme will be important for the following two reasons:
- If the scheme is to be shared and internal membership is not allowed, then the pension sharing order that needs to be applied will be a percentage of the CETV. The Pension Sharing report will use the current CETV to calculate this figure.
- Once a Pension Sharing Order has been granted against a DB pension scheme, on implementation the CETV will be recalculated based on current assumptions before the funds are sent to the new provider.
If there is a significant time gap between the report being composed and implementation taking place, then the CETV may be significantly different – and potentially lower.
This could leave the recipient spouse out of pocket when compared to the calculations that were performed by the pension actuary.
How are CETVs calculated?
Until very recently we have seen historically low levels of inflation and interest rates. CETV values have been historically high as the cost of providing the pension income has become more expensive.
A gilt pays a fixed amount of interest (known as the “yield”) over a pre-determined period – for example, 15 years. The yield is the interest rate on a gilt based on its buying price, so when the price of a gilt goes up, the yield goes down and vice versa.
A CETV is the lump sum that a party receives by giving up the benefits in their DB pension by moving part or all these benefits to a defined contribution (DC), or “money purchase”, scheme. A CETV is calculated based on what the scheme actuary estimates it will cost to provide the benefits being given up.
To calculate the CETV, a scheme actuary will consider a number of factors including:
- Population longevity
- The economic outlook
- The scheme retirement age
- Inflation expectations.
Gilt yields are also a crucial input into this. By considering these factors, the scheme administrators can estimate what it is likely to cost them to provide the annual pension income at the normal retirement date. This figure is then discounted back to today’s date to provide a current CETV.
CETVs are now at their lowest level since 2014
2022 has seen average CETVs fall significantly. Indeed, pension trustee XPS Pensions Group in their Transfer Value Index suggest that CETVs are now at their lowest levels since November 2014.
Mike Barlow of XPS Pensions Group says: “Recent rises in gilt yields have seen transfer values plummet for most members. This is likely to make a transfer look less attractive.”
However, the recipient of an external transfer value from one of these schemes rarely has a choice. Consequently, they will be forced to accept the lower transfer value.
To give you some idea of the magnitude of the declines in CETVs, according to XPS’ Transfer Value Index, at the start of 2022 an “average” transfer value from a DB scheme was £270,000. An equivalent transfer value today is £203,000 – a fall of nearly 25%.
For the purposes of splitting pensions on divorce, a growing number of DB schemes no longer offer internal membership for an ex-spouse who is receiving a pension share.
In fact, outside of public sector schemes, it is very rare. Instead, they will offer an external share only.
Here, the ex-spouse will not receive a guaranteed income akin to that afforded to the member of the scheme, but will instead need to transfer their share to a DC scheme (usually a personal pension).
If the CETV has reduced in value, this potentially means a greater share from the scheme will be required to provide equality of income. For those recipients of a pension share calculated and agreed some time ago, it will also mean that they may well see the actual value transferred to their new scheme being much lower than expected.
In a recent case that came across our desk, the actual transfer value received was £690,000 whereas the amount calculated in the Pension Report last year was £790,000.
Actions you can take
Clearly, there is little direct intervention that can be taken here to mitigate the problem. However, actions that you may wish to take include:
- Consider having the pension sharing figures recalculated if there has been a significant delay between the original Pension Sharing report and the divorce agreement being finalised. There will be costs involved with doing this but the benefits of a recalculation could far outweigh them.
- Encourage your client to use a financial planner when implementing the Pension Sharing Order as knowledge of pension sharing can help to expedite matters and thus potentially reduce the implementation time.
In these volatile times, it is crucial that we use the most up-to-date figures when determining how to split assets on divorce. If you have any questions, we’re here to help.
Get in touch
If you have clients who would benefit from pensions on divorce advice, please get in touch to find out how we can assist. Email firstname.lastname@example.org or call us on 0118 987 6655.