I have mixed feelings about my Economics ‘A’ Level. An intuitive grasp of the subject turned out to be a double-edged sword; sitting at the back finding it all rather easy earned reports which damned with faint praise, along the lines of “it would be good to see Faisal’s excellent understanding supported by a more diligent attitude in class”.
One topic emerging from the mists of time is the “substitution effect”: as the price of coffee rises, consumers switch to tea and vice versa.
As we all know, other than being caffeine-based, tea and coffee are very different products, so there is only a weak substitution effect in the real world – it’s not the best example to use, yet it still appears in Economics courses all the time!
But, in the end, the bad substitution example doesn’t harm anyone. My classmates and I didn’t leave school that grey afternoon 25 years ago and make life-changing decisions based on a faulty understanding of tea and coffee as substitutes.
Getting into hot water
So why have I taken you on a short trip back to my school days?
Because a far more harmful “substitution” may be taking hold in the financial industry.
It is now fairly common to hear EIS funds being discussed in the same breath as pensions. I would urge caution against a potentially misleading conflation of very different investment vehicles.
To be clear, we like EIS funds – so much that we recently called them the “Holy Grail” – for the right client, in the right circumstances and for the right reasons. You can be a fan of both coffee and tea: I prefer coffee in the morning, tea in the afternoon and neither after 6pm!
But those “right reasons” do not include simply to swap one set of tax reliefs for another.
At worst, simplistic replacement of pension contributions with EIS investments may be sowing the seeds of the next big mis-selling scandal. As our industry knows all too well, it is not a case of “buyer beware” but “adviser beware”.
Why are investors looking to EIS funds as alternatives to pensions?
The short answer is tax – and the long answer is psychology.
Personal finance sections frequently report on how, as the tax benefits of pensions have declined, interest in other tax efficient investment vehicles such as VCTs and EIS funds has increased (perhaps this should be in Economics textbooks instead of tea/coffee!).
As we approach 5th April, expect more of these to appear. Purely from a tax relief point of view, the attraction is obvious.
However, while the tax angle gets plenty of airtime, there is not often much discussion of the underlying investments.
Not-so-smart shortcuts
There’s also another type of “substitution” at play here and it is do with how our brains work. Steven Novella draws on Daniel Kahneman, godfather of behavioural finance and author of Thinking, Fast and Slow, in an excellent blog post on the substitution heuristic and how it works in different contexts.
Just as it’s easy and convenient to think of “tea / coffee” as substitutes, it can be very tempting to do the same with “pensions / EIS” because of easily recognisable, shared features – in this case tax relief.
It turns out our brains are wired to look for these quick connections which can sometimes be flawed. In the “tea / coffee” case, lazy or careless “substitution” might result in a disappointing hot drink; but the other one can lead to poorly-framed and costly decisions.
This is especially so if trusted sources, such as newspapers and advisors, talk about the two wrappers without adequate distinction.
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 misguided and dangerous.
Most pension portfolios are highly diversified, global and liquid. They will be made up of usually hundreds or thousands of investments across equities, bonds, commodities and alternatives.
EIS funds, on the other hand, hold concentrated portfolios – typically 5 to 15 investments – in small, early-stage, high-risk UK companies.
On an investment basis, pensions and EIS funds could not be more different to each other.
Just because an investor used to put £100,000 a year into one tax-efficient wrapper – a pension – does not mean that it’s automatically the right thing simply to allocate the same amount into a very different vehicle – EIS funds – when the first one is no longer available.
EIS funds and pensions are very different propositions and should be treated as such.
My advice to anyone thinking of EIS and pensions in the same vein is simple: stop. Get up and go and make a cup of tea – or coffee – and remind yourself of how different they are to each other. And then just double check whether you are thinking about this issue in the right order:
CLIENT > INVESTMENT > TAX
Letting tax considerations drive investment decisions is a bad idea. Investors and advisers should take extra care to ensure they do not fall into this tempting trap.