How pension freedoms affected the VCT market

Jason Hollands, managing director of business development and communications for Tilney, points the finger squarely at HM Treasury for making the tax treatment of pensions less favourable over recent years, and says this has helped fuel demand for venture capital trusts (VCTs).

He comments: "There is no doubt that aggressive reductions in the lifetime allowance (LTA), as well as restrictions on the pension annual allowance - such as the tapered allowance for high earners - have been a factor fuelling interest in VCTs as an alternative option for tax-efficient investing."

According to HM Revenue & Customs' VCT statistics, 2016 to 2017 tax year saw £570m invested in VCTs. 

This was an increase on 2015 to 2016 - and was the highest amount invested in one year since the heady pre-financial crisis days of 2005 to 2006.

But 2017-2018 has also been a stellar year for VCT investment. Although the final end-of-year figures are not yet out, already 2017 to 2018 looks to be on course to overtake 2016 to 2017.

The table below, sourced from Octopus Investments, gives a snapshot of the rising levels of VCT investing over the past six years.

As at 12 March 2018, total VCT fundraising had reached £550m, with weeks still to go before the deadline. This is more than double the 2012 to 2013 tax year fund raise of £270m.

Certainly the figures seem to suggest a surge of interest in VCTs that might coincide with recent tax tampering on pensions - as well as reductions to the erstwhile favourable tax regime on landlords and buy-to let.

Paul Latham, managing director of Octopus Investments, comments: "The ever-growing demand for VCTs is not surprising, when you consider the recent changes to pensions legislation, restrictions on the LTA and the buy-to-let market.

"As these areas become squeezed, people are increasingly looking to VCTs to provide them with a credible way of investing in a tax-efficient manner."

The chart, below, provides a snapshot of total VCT investing across some of the largest VCT funds in the UK as at 6 March.

Source: Tilney

Pensions taxation

For Alex Davies, chief executive of Wealth Club, "pensions changes have been the biggest driver for VCT investment".

He explains: "When you consider the maximum amount you can hold in a pension has fallen from £1.8m in 2011 to 2012, to £1m today, and that higher earners can put in as little as £10,000 a year, compared with up to £225,000 10 years ago, this is hardly surprising."

According to Mr Davies, for those who are already reasonably wealthy, it is clear that "investing solely in a pension is unlikely to provide you with sufficient funds to get you through retirement".

Jack Rose, head of tax efficient investment at LGBR Capital, agrees: "Undoubtedly [pensions changes] have broadened the investor base, increased demand and raised awareness for the products.

"People who are now unable to put £40,000 into a pension or are coming close to the LTA are turning to VCTs as an alternative."

And this is the case for people in all walks of life and career choices: teachers, doctors and business owners, he adds, which is why Mr Davies believes investing in VCT and EIS is "becoming mainstream".

A word of caution from Mr Latham: "It must be noted that capital is at risk with a VCT, and the tax treatment does depend on an individual's circumstances. 

"Tax reliefs also depend on the VCT maintaining its VCT-qualifying status."

Stuart Veale, managing partner for Beringea, acknowledges that the underlying investments are riskier, but adds: "The large number of companies in VCTs' portfolios diversifies much of this risk away.

"The holding period is only five years, rather than to age 55, after which the VCT shares can be sold and the proceeds invested in another VCT for additional tax-relief."

He also reminds that "income from a VCT is tax-free, whereas income from a pension is taxable". 

Pension freedoms

In April 2015, the pension freedom and choice regime came into force, meaning from age 55, people in the UK are entitled by law to access their pension as they wish, subject to taxation and to any rules around defined benefit (DB) scheme membership.

Whether this has given people more freedom to contemplate the relative merits of VCTs and decide to invest some of their pension money in them, is not yet clear. Some people believe pension freedoms has had an effect.

Darius McDermott, managing director of Chelsea Financial Services, says: "We have seen an increased number of people interested as, rather than topping up pensions, they are looking for other tax-efficient investments, so pension freedoms and tax changes have made a difference."

In FTAdviser last year we reported on research from VCT provider YFM, which found that 54 per cent of VCT investors under 60 chose VCT investment instead of a pension fund. 

It is worth noting an adviser commenting under the article says VCTs have been used increasingly in retirement planning.

But according to George Bull, senior tax partner for RSM UK: "Pensions tax changes seem to have boosted VCT investment, but the pension freedoms are unlikely to have had any material impact."

He highlights that although the 2016 to 2017 tax year saw a record £570m invested in VCTs, which coincided with the lower annual and lifetime allowances for pension contributions, as well as pension freedoms for access to pension savings, he thinks the high levels of VCT investment might not necessarily be a result of people being able to get hold of their pension pot at age 55.

Mr Bull explains: "Most people might not choose to withdraw a pension lump sum and invest in a VCT - this could be a high-risk investment strategy."

David Goodfellow, head of wealth planning for UK and Europe at Canaccord Genuity Wealth Management, says: "I do not believe pension freedoms have had much of an impact, but the LTA and reducing annual allowance has definitely had an effect.

"This has led more advisers to come into the space, but there is a concern that many new entrants do not really understand the suitability issues.

"Just because someone cannot make significant pension contributions, they are not necessarily open to VCT risks."

There is a concern that many new entrants do not really understand the suitability issues. David Goodfellow

Additionally, Tim Stovold, head of tax at Kingston Smith, points out the tax advantages of VCTs need to be balanced against the inherently higher risk.

"The increase in VCT investments is good for those companies seeking to raise money but is a worrying sign for investors turning to risky VCTs following HM Revenue & Customs capping the pension contributions."

While an investment in VCTs will generate tax-exempt income, and might be seen as similar to a pension contribution in tax terms, he warns a VCT is "completely different to the relative safety of a pension".

"Planning your retirement around a VCT portfolio is a high-risk strategy which could have a sting in the tail."

Other factors

Buy-to-let has already been mentioned; as Annabel Brodie-Smith, director of communications for the Association of Investment Companies (AIC) asserts, the "new limits on mortgage interest relief and higher rates of stamp duty" have helped drive investors to look for "complementary investment solutions to plan for their retirement".

She comments: "Many investors have turned to smaller company investing as a clear way to diversify their portfolios in a tax-efficient way.

"As part of this trend, VCTs have become a mainstream option for investors who are comfortable with the risks of investing in small, unlisted companies."

Mr Hollands also believes the "clampdown on aggressive forms of loophole-driven tax planning" has meant investors are now more likely to be focusing on tax-efficient schemes which have statutory backing, such as enterprise investment schemes and VCTs, rather than things such as film investments.

Then there's the never-ending story of the quest for income at a time when yields are depressed on traditional asset classes, spreads between sovereigns, corporates and even high-yield fixed income are narrower than they have been, and the return on cash is still a paltry 0.5 per cent bank base rate (or less in a high-street cash Isa).

Currently: 

• Yield on FTSE 100: 4.02 per cent (as at 28 February).
• Yield on FTSE All-Share: 3.78 per cent (as at 28 February).
• Bank base rate: 0.5 per cent.
• Highest one-year fixed rate cash Isa: 1.5 per cent (Virgin Money).
• Yield on 10-year UK Gilt: 1.44 per cent.
• Yield on 10-year US Treasury: 2.75 per cent.
• Average yield on a VCT: 6.7 per cent.

Source: AIC/Morningstar/Savings Champion/FTSE Russell

Mr Latham comments: "A need for income means many more advisers are now looking for credible alternatives to help their clients complement their existing [pension] arrangements."

The graph on live average cash rates from Savings Champion (below) highlights the paltry returns currently being yielded by cash Isas and fixed-rate bonds.

"Upfront tax relief, tax-free growth and income mean a number of investors are turning to VCTs to supplement their pension saving," adds Ms Brodie-Smith.

Mr Hollands says the strong income generation has also helped to make VCTs more attractive, as yields in this asset class are both "high and tax-free".

He says: "VCTs can therefore be a useful part of the mix when compiling a retirement income strategy.

"However, I would urge a little caution here, as new deals by VCTs into younger companies are likely to result in more erratic future returns than the past.

"Investment into earlier phase companies are likely to have more binary outcomes: some big winners, but some flops that could make dividends a bit more lumpy."

simoney.kyriakou@ft.com