EIS and VCTs increasingly on investors’ radar

John Glencross, Chief Executive, Calculus Capital looks at the reasons – most notably the scaling back of pension tax relief over recent years – why EIS and VCTs are appearing on the radar of an increasing number of investors

Pensions are not what they used to be; certainly not for high earners and those who have accrued large funds anyway. Over the past five or six years, successive governments have reduced the tax relief paid out – some £50bn a year currently – as they’ve tried to reduce the budget deficit. This began in the 2011-12 tax year, when the annual allowance was cut from £255,000 to £50,000, an amount that’s since been trimmed to £40,000. More recently a complicated tapering system has been imposed on those earning more than £150,000, which means those at the upper end of the system’s scale can now only save £10,000 a year into a pension. The lifetime allowance has likewise been cut substantially, nearly halving, from £1.8m in 2010-11 to £1m today.

Pensions company Royal London recently calculated that these reductions, combined with dramatic falls in annuity rates and the effect of inflation, have over 10 years resulted in a two-thirds drop in the value of pensions for higher earners who save up to maximum pension limits. To put it another way, the annuity income that could be bought from a pension pot that has reached the lifetime allowance is 66% less today than it was in 2006.

Additionally, Royal London warned that because future increases in the lifetime limit will be restricted to annual CPI inflation, not only the ‘super wealthy’ will be caught by the lifetime limit in years to come, but increasingly so will others. More broadly, the consequences of the regular ‘salami slicing’ of pension benefits could be, said the company, more people turning away from pensions, put off by their complexity and a sense that further changes that reduce their benefits are inevitable.

I don’t wholly agree with this conclusion – tax relief of 20% or 40% on pension contributions remains a significant incentive to save and provided it remains in place (or something similar), I expect that most people who can save into a pension will continue to do so. Still, there’s no doubt that the squeeze on pensions is having a negative effect on how they are perceived, and that those most affected by the changes – higher earners and/or people nearing the lifetime limit – are no longer seeing their retirement provision solely in the context of pension saving.

Advisers and investors now regularly tell us that the greater limitations placed on pensions have encouraged them to newly consider, or use more extensively, other tax-efficient investments, such as EIS funds and VCTs.

If the past 10 years has not been a golden period for pensions, the same is not true of the Enterprise Investment Scheme (EIS). In 2011-12, the year in which the annual pension allowance fell by more than £200,000, tax relief on EISs was increased from 20% to 30% and the maximum amount individuals could invest in EIS was raised from £500,000 to £1m per tax year.

Were the more generous limits on EIS were made with an eye to offsetting some of the restrictions on pensions? Possibly, but I doubt it would have been the primary motivation for the changes. More likely, the government recognised that EIS was an effective means of providing funding for smaller, growing companies, and that the scheme could be made more effective by improving the offering; benefiting investors, the enterprising companies in need of funding and, with their growth, the wider UK economy too.

The changes have proved remarkably successful and EIS fundraising has been growing ever since. In 2011-12, the amount raised through EIS more or less doubled from the previous year, to more than £1bn and has continued to rise, reaching a record £1.8bn in 2014-15. No doubt with this success in mind, in 2012 the government created a new scheme based on EIS, the Seed EIS, aimed at start-ups and micro-businesses, offering 50% tax relief to investors.

In addition to changes to pensions, we believe the growing fundraising levels for EIS funds in recent years can be attributed to a few other factors:

Low interest rates
EIS funds, and VCTs, have been seeing bumper fundraising levels in recent years and we believe the low interest rate environment is a factor. It has been a specific intention of monetary policy, in the form of Quantitative Easing, to encourage investors to place their money in ‘risk assets’. For many investors, this has meant listed equities, but not exclusively so. Unlisted equities have benefited too, including EIS, the generous tax reliefs of which considerably enhance their appeal to investors looking for a decent return.

Rewarding entrepreneurialism and helping to stimulate economic growth
Investors are increasingly telling us that they want to ‘put their money to work’ – understandable if one of the alternatives is earning close to zero on cash deposits. They like the idea that their money is not only being made to work for them, but also for promising growth companies. EIS funding is truly part of an economically virtuous circle in this respect.

Stock market volatility and valuations
Increased stock market volatility and higher equity valuations may be factors in the growing popularity of EIS funds. Mainstream, listed equities have served investors fairly well since the financial crisis, but markets have become more sensitive and prone to wild swings in valuation in the years that have followed. There’s also a sense that, after several years of good returns, many global equity markets have reached fair, or even full, values and the next big move is likely to be down. As such, taking profits and switching some listed equity holdings to an EIS fund is a trend we have observed among some investors.

Rising Capital Gains Tax receipts
Linked to strong stock market returns are rising CGT receipts. In 2014-15, the government collected £6.9bn in CGT, the second highest figure to date. The previous year, gains from ‘financial assets’ – essentially shares – were responsible for 72% of the £5.5bn collected in CGT and it would not be a surprise if financial assets were responsible for a similar proportion of 2014-15’s CGT take.
For investors facing hefty CGT bills, EIS holds considerable appeal. EIS gains are exempt from CGT, and CGT deferral, a feature unique to EIS, means investors can invest their gain through EIS and defer the liability that would be due on that gain. Deferring the gain may mean the amount owed could be reduced if offset against losses elsewhere.

Rising IHT receipts
Inheritance tax receipts are also rising – in 2015-16 they were up 22% to £4.7bn compared to the previous year. EIS investments are 100% exempt from IHT after two years, another reason they are becoming an important element in tax planning strategies.

Let’s not forget the risks
Of course, investing in unlisted smaller companies does carry risks and not every investment is a success. But those that lose money are subject to loss relief, another unique benefit of EIS investing, which can offset losses up to 61.5%, or 61.5 pence, for every pound invested in a particular company.

This article was also covered by Professional Adviser