EIS and VCTs Are Not Pensions
Advisers are being encouraged or sometimes even urged to promote VCTs and EIS funds as alternatives to pensions. In the press, it is now commonplace to describe an increase in interest in VCTs and EIS funds as substitutes for pensions. I would urge caution against a potentially misleading conflation of very different investment vehicles.
To be clear, we are big fans of VCTs and EIS funds – for the right client, in the right circumstances and for the right reasons. Those reasons do not include the client’s desire to replace tax reliefs no longer available through pensions with reliefs from VCTs and EIS funds.
At worst, simplistic replacement of pension contributions with VCT and EIS investments may be sowing the seeds of the next big mis-selling scandal. As the industry well knows, it is not a case of “buyer beware” but “adviser beware”.
Why are clients looking to VCT / EIS as alternatives to pensions?
Unfortunately, the short answer is tax. Personal finance sections frequently report on how as the tax benefits of pensions have declined, interest in tax efficient investment vehicles such as VCTs and EIS funds has increased. I do not often see much discussion of the underlying investments.
Contributing to a personal pension remains highly tax-efficient: the government will add £4,000 to every £6,000 invested by a 40% taxpayer. After years of increasing popularity, mounting costs to the Treasury (in the short-term) and concern that the highest earners were benefitting the most, successive governments have gradually restricted both the annual amount that can be invested (£40,000 per year, typically generating £16,000 of tax relief) and the total size of a pension pot. The highest earners are now restricted in some cases to a maximum contribution of £10,000 per year.
VCTs and EIS funds, on the other hand, have seen consistent and increasing support from governments of all colours. Annual investment limits have remained the same for VCTs (£200,000) and increased substantially for EIS (now up to £2m subject to conditions). The tax relief on offer is 30%. If an investor used to put £100,000 into his or her pension but is now restricted to £40,000 or less, purely from a tax relief point of view the attraction of investing into VCTs or EIS funds is obvious.
What’s wrong with swapping one tax relief for another?
It’s the investment, stupid, to paraphrase Bill Clinton. The notion of switching investment vehicles purely on the basis of their tax relief is plain wrong.
When we say “pension”, typically that means a portfolio of 10 to 20 investment funds, each with 30 to 300 individual investments in mostly liquid companies, across many asset classes, sectors and regions of the world. There are few restrictions on the nature of the companies and what you often have is a highly diversified, liquid portfolio.
A typical VCT will have somewhere from 10 to 40 investments in small-to-medium sized UK companies. EIS funds often hold 4 to 10 investments in early stage, small UK growth companies. In both VCTs and EIS funds, the rules have been tightened to force them to invest into high growth, early stage and risky businesses (quite rightly, as this meets the government’s intention of channelling capital into early stage businesses with these tax reliefs).
In other words one is usually comprised of hundreds or even thousands of diversified, liquid underlying holdings; the other is made up of a concentrated set of small, usually unquoted, high growth / high risk companies in the UK (and there is a bit of a clue in the name: Venture Capital Trust).
Why are investors, advisers and commentators still comparing pensions with VCTs and EIS funds?
I worry that the lure of tax relief can blind many in the industry to the underlying investment rationale and consideration of client circumstances. Building a portfolio of venture capital investments, using VCTs and EIS funds to help diversify and to generate tax relief, as part of a client’s overall wealth is often a perfectly good idea. So is having long term, liquid diversified portfolios of mainstream investments held in a pension with different tax reliefs and restrictions. The two are very different propositions and should be treated as such.