Divorce settlement agreements

The financial services industry is linked in various ways to the attorneys’ profession. This is especially apparent when attorneys drafting divorce settlement agreements are faced with various financial products like pension funds, retirement annuity funds and endowments. It is imperative that every practising attorney understands the rules of each particular product that forms part of the financial planning process.

Divorce settlement agreements

– What every attorney should know about the financial services industry

Source: Tricia Reed BA LLB HDip (Tax) (UKZN) CFP (UFS) is a senior legal adviser to an insurance company in Durban.

The financial services industry is linked in various ways to the attorneys’ profession. This is especially apparent when attorneys drafting divorce settlement agreements are faced with various financial products like pension funds, retirement annuity funds and endowments. It is imperative that every practising attorney understands the rules of each particular product that forms part of the financial planning process.

At the outset, practitioners should be aware of the issues set out below.

Endowments

These are savings vehicles that are subject to several Acts, the most important being the Long-term Insurance Act 52 of 1998. Section 54 read together with the regulations, states such rules. Unlike many other financial products, endowments can be ceded, and are often ceded in terms of divorce settlements. However, attorneys should be aware that this may have the effect of making such policies second-hand policies and, therefore, in terms of the eighth schedule to the Income Tax Act 58 of 1962, subject to Capital Gains Tax.

Attorneys acting for a client who is the owner of such a policy, should discourage the client from making assertions in a divorce agreement regarding the maturity value of the policy. Financial planners give clients illustrative values of what the policy may mature at. These figures are dependent on many factors. A client may find himself in the situation where the matured policy value is far lower than anticipated. The client, having guaranteed a higher figure in the divorce agreement, finds himself in the unattractive position of having to make up for that shortfall.

Retirement annuities

These are savings which have as their primary purpose the provision of capital at retirement. Unlike an endowment, which may have a term of five years and is fairly liquid, a member of a retirement annuity can never withdraw those funds in full, cannot retire from the fund before the age of 55 years and, when he does so, he can take a maximum of one-third of the fund value in cash. In addition a retirement annuity can never be ceded. Thus a divorce agreement that allows for the cession of the retirement annuity from the member spouse to the non-member spouse cannot be given effect to.

It is also prudent for attorneys to establish what type of investment the client holds. References to endowment policies in the divorce agreement are often incorrect and the underlying policy is very often a retirement annuity policy, which cannot be ceded. The effect is that the parties cannot carry out what they had agreed to, and the attorney may have to start renegotiating with two irate clients.

Pension funds

Pension savings are dependent on an employer-employee relationship. Pension moneys cannot be withdrawn except on resignation or retirement. On resignation, the full pension benefit can be withdrawn. Tax is paid at the member spouses’ average tax rate. At retirement only one-third of the pension benefit can be taken in cash, the remaining two-thirds must be used to purchase an annuity (a pension). Often divorce agreements drafted by attorneys allow for 50% of the pension interest to be paid to the non-member spouse. No mention is made of tax. If the divorce occurs close to the member spouse’s retirement, this agreement cannot, in practice, be given effect to as the member spouse can commute only 1/3, on which he then has to pay tax. The amount available to the non-member spouse is far less than the 50% agreed to at divorce. In addition, tax is seldom mentioned.


Annuities

Annuities that are being received when the spouses decide to divorce often form the single largest asset in the estate and are often the only source of income. The annuity (pension) is paid out to the individual spouse who was previously the member of the retirement annuity or pension fund.

Attorneys drafting settlement agreements often allow for the ‘splitting’ of the annuity and the payment of half of the annuity into the bank account of the non-member spouse. Attorneys should be aware that in practice insurance companies which underwrite the annuity (or pension) will not pay into any account other than the member spouse’s. In addition the member spouse pays all of the tax.

Attorneys must be aware of what the product provider will allow in practice. Often the annuity is the largest asset in the estate and while it would be more convenient for the members to pay the member and non-member separately, this cannot be done. The effect of this is that the member spouse will receive the annuity and pay it over similar to a ‘maintenance’ payment to the non-member spouse. Attorneys should also be aware that insurers will not pay funds into any bank account other than an account held in a local bank.

Income tax

As mentioned above, attorneys would do well to educate their clients on the effects of income tax involving pension withdrawals and payments from retirement annuities and pension funds at retirement. If a non-member spouse is, for instance, in terms of the settlement agreement entitled to half the pension interest as at date of divorce and this amount is R1 million, then does the non-member spouse obtain this money as an after-tax amount, or will he in fact lose as much as 30% of the amount as this amount is subject to tax at the member spouse’s average rate of tax?

Many settlement agreements are silent on the tax treatment of pension payments. The non-member spouses may not fully understand that pensions are subject to income tax and may therefore get a rude awakening when the R1 million they expect to receive is R700 000 after tax. The shortfall is substantial and the attorney would do well to clear up expectations so that there is no disappointment on the part of the client.

In addition attorneys must be aware that only one-third of a retirement annuity or a pension fund can be commuted, that is, taken in cash. Again such a commutation will be subject to tax at the member spouse’s average rate. So if a client is promised 50% of the pension interest and the divorce date and retirement date are close together, such an agreement cannot be given effect to as the member spouse may withdraw only one-third of his benefit, leaving a shortfall which must be commuted to an annuity. The effect of an annuity payment is discussed above.

While the South African Revenue Services (Sars) has stated that it will tax the member spouse who may thereafter recover the tax from the non-member spouse, it would be more prudent to alert a client to the fact that there are tax consequences, and such consequences can then be dealt with correctly and effectively in the settlement agreement. This way both parties have a clear understanding of the after-tax amount that they will receive.

Problems such as the above were well illustrated in the case of Old Mutual Life Assurance Company (SA) Ltd and Another v Swemmer 2004 (5) 373 (SCA).

The facts briefly were that the respondent was divorced from her husband. As part of the settlement agreement, Mrs Swemmer, the non-member spouse, was awarded ‘as her exclusive property’ two retirement annuities, one with Old Mutual and one with Sanlam. The husband was the member of the retirement annuity funds and after the divorce, continued to pay the premiums.

When the member spouse turned 55 (the earliest date on which you can retire from a retirement annuity (a person may never withdraw)), the respondent requested the insurers to pay the full proceeds of the fund to her. The contract term of the annuities ran until the member turned 60, but the non-member spouse as the ‘owner’ of the policies, wanted the funds on the member spouse’s 55th birthday. The insurers had objected on two grounds – the first related to s 7 of the Divorce Act 70 of 1979, and the second to the relationship between the member and insurer.

Section 7(7) of the Divorce Act states that ‘(a) In the determination of the patrimonial benefits to which the parties to any divorce action may be entitled, the pension interest of a party shall, subject to paragraphs (b) and (c), be deemed to be part of his assets’. Pension interest is defined in the Act in relation to a party to a divorce action who,

‘(a) is a member of a pension fund (excluding a retirement annuity fund), means the benefit to which that party as such a member would have been entitled in terms of the rules of that fund if his membership of the fund would have been terminated on the date of the divorce on account of his resignation from his office; (b) is a member of a retirement annuity fund which was bona fide established for the purpose of providing life annuities for the members of the fund, and which is a pension fund, means the total amount of that party’s contributions to the fund up to the date of divorce, together with a total amount of annual simple interest on those contributions up to that date, calculated at the same rate as the rate prescribed as at that date by the Minister …’.

The insurers argued that they could not pay out the full proceeds of the policy as though it ‘belonged’ to Mrs Swemmer, as the definition of pension interest as contained in the Divorce Act makes allowance only for the amount in the fund as at date of divorce to be paid. Should they pay the full proceeds to the respondent, they effectively allowed for a cession of the policy and it is stated clearly in s 37A of the Pension Funds Act 24 of 1956, that

‘no benefit provided for in the rules of a registered fund … or right to such benefit, … shall, not withstanding anything to the contrary contained in the rules of the fund, be capable of being reduced, transferred or otherwise ceded, or being pledged or hypothecated, or be liable to be attached …’.

A further argument that the insurers had was that the relationship was between the insurer and the member of the fund: The non-member could not be the ‘owner’ and therefore could not dictate as to when the policy should be paid out. In addition, they could not pay directly to the non-member.

The court held that indeed the relationship is between the member and the insurer: The insurer could not pay out more than that which was allowed in terms of s 7 of the Divorce Act, and that the non-member cannot insist on the policy being matured earlier (or later). The court held further that the non-member spouse did not become the ‘owner’ of the policy and therefore could not dictate the relationship.

This case serves to illustrate what is a widely misunderstood concept of financial products. If as an attorney in a divorce matter, a pension or retirement annuity forms part of the assets of the parties, care must be taken to ensure that a ‘cession’ is not effected. In addition it must be explained to clients that pension interest is paid only on the date of withdrawal (pension funds only) or retirement by the member spouse from the fund. In other words that date on which the pension accrues to the member. This may in practice be 20 years after the divorce. This effectively means that the non-member spouse will receive the pension interest with no interest or growth only on that date. Attorneys would be wise to use the time value of money calculations to illustrate to litigating parties how the real spending power of money is halved approximately every eight years (known as the ‘rule of 72’) and such an illustration may encourage parties to see more clearly what a reasonable settlement as regards pension and retirement annuities could be.

Government has acknowledged that there are inequitable consequences regarding pension moneys on divorce. In addition, within the broader framework of State subsidies and old age pensions, reform needs to be undertaken. There are currently proposals to ensure that in future a more equitable situation on divorce arises for both the member and non-member spouse. These amendments are not imminent and attorneys need to apprise themselves of current practices.

 

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