Is the Cash Equivalent Value (CEV) appropriate to use for offsetting?

The CEV will rarely be appropriate to use as an offsetting value (or balance sheet value) for a pension. Firstly CEVs are always expressed in “gross of tax” terms as they represent the value that the pension scheme/arrangement is placing on the pension benefits gross of tax. For offsetting purposes however what is important is what you take out of the pension and this is after any tax that needs to be paid. Retirement lump sums from a pension are usually tax free, but pension income is subject to income tax. The offset value can therefore be generally thought of as:

[Fair gross value of the pension benefits] x [1 – average tax rate in retirement]

The “average tax rate” will usually be less than 20% for basic rate tax payers as one quarter (25%) of the pension can usually be taken tax free at the time of retirement.

It is important when considering settlement by offsetting to ensure that a suitable “gross value” has been placed on each of the parties’ pensions to compare these fairly, and the CEV can be a starting point for this. When simply considering defined contribution pensions without any additional guarantees, the CEV may be often be considered to be a fair valuation as this would be expected to simply be the assessed value of the assets in which the pension is invested. When considering defined benefit pensions however, the CEV will have been calculated based upon the assumptions of the Scheme Actuary (for private sector pensions) or the Government Actuary’s Department (for public sector pensions) and hence these values may not be suitable for offsetting, as they have not been calculated using consistent methods and therefore do not necessarily represent appropriate balance sheet values.

For example, if one party has a Local Government pension with a CEV of £250,000 and the other party has a defined contribution pension fund with a CEV of £350,000 then it would appear that the defined contribution pension is more valuable. However, in this example the Local Government pension is expected to provide an index-linked pension income of £21,000 per annum from the member’s State Pension Age whereas the cost of purchasing an index-linked annuity (after considering future investment returns) means that the defined contribution pension may only be expected to provide an income of £20,000 per annum from State Pension Age.

By means of another example, if two parties have defined benefit pensions from two different pension schemes, one of these may have a CEV of £300,000 and the other a CEV of £400,000 even though both pension assets are expected to provide an index-linked income of £15,000 per annum from age 60. Differences such as this may arise where the two pension scheme’s actuaries have used alternative assumptions when placing a value on pension benefits.

The gross value of pension rights should use consistent assumptions when valuing pension benefits for offsetting purposes in a divorce settlement and it would be recommended that a pensions on divorce expert (PODE) is used to determine appropriate offset values in this circumstance.