Best VCTs for your retirement

Venture capital trusts are one of the investments that advisers and providers suggest you turn to because they have tax advantages. These include 30 per cent income tax relief when you buy new shares and hold them for five years, tax free dividends and no capital gains tax (CGT) when you sell the shares.

During your pension accumulation phase when you are working you may be incurring high rates of tax so VCTs could help reduce your overall tax bill. Matthew Woodbridge, vice president at Barclays Wealth and Investment Management, suggests during the pension accumulation phase considering investing incremental amounts into VCTs over a number of years to spread your risk across the economic cycle.

Many VCTs offer high yields so are useful for those seeking income. The Association of Investment Companies (AIC) recently reported that 58 per cent of VCTs are yielding over 5 per cent, with the VCT sector average yield being 7.4 per cent. The average VCT Generalist company offers a yield of 8.1 per cent, and the average VCT AIM Quoted offers 5.6 per cent.

However, the reason VCTs are given generous tax breaks by the government is because they are high risk investments. VCTs typically invest in early stage unquoted smaller companies which need a financial injection to grow further. While these can make strong returns you can also incur large losses on them, and they are volatile.

Most advisers recommend that you do not consider investing in VCTs unless you have used up your annual or lifetime pensions allowance, and your annual individual savings account (Isa) allowance which is currently £15,000, and rises to £15,240 in the 2015/16 tax year.

"Just because you have maxed out your pension does not mean that you should automatically consider VCTs," says Mr Woodbridge. "VCTs should form part of a large portfolio and you need to hold them for at least five years. While VCTs are very attractive from an income perspective they are not an automatic step and I would suggest people take professional advice on whether to invest in them."

You should also consider how VCTs sit alongside the rest of your portfolio, for example, do you already have exposure to smaller companies? "If you do you may need to sell some existing investments if you buy VCTs," says David Hazelton, head of business development at Raymond James Investment Services. "Diversification is important so think about the overall balance of your portfolio."

"VCTs can be part of the amoury but are not an alternative to pensions," says Mr Hollands. "Do not lose sight of the fact that VCTs are a niche investment so are very much an add-on to your retirement savings."

From April this year pension investors will have more choice on how to take their retirement income following sweeping changes announced in the budget last year. People will no longer be compelled to buy an annuity and could take their whole pension as cash provided they are aged over 55.

You can invest up to £200,000 into VCTs a year. However, advisers strongly advocate that come April you do not put all your retirement money into VCTs. Mr Hollands argues that this would be a big mistake as you still take a tax hit: while 25 per cent of your pension is tax free the rest is taxed at your marginal rate, which at 40 or 45 per cent respectively for higher and additional rate tax payers, is particularly punitive. While income tax relief on VCTs would alleviate some of this tax bill, you would still have an income tax liability. However, Mr Hollands says you might choose to put some of your tax free lump sum into VCTs to generate income alongside an income drawdown strategy for the rest of your pension.

Also, when you are retired you may not be paying 40 or 45 per cent income tax so VCTs would not be as useful. "You need to consider if the risk is worth it – especially if you are not a higher rate taxpayer," says Colin Low, a chartered financial planner with Kingsfleet Wealth. "The tax free dividend is not guaranteed."

Mr Woodbridge adds that you may also want to be reducing your risk profile in retirement and VCTs are high risk investments.

VCT dividend reinvestment

Even if you are not seeking income before you retire and you are still contributing to a pension, you could reinvest the VCT dividends using a dividend re-investment scheme (Dris) or a dividend re-investment plan (Drip).

Philip Rhoden, director at discount broker Clubfinance, says: "Both schemes allow the investor to reinvest their dividends to gain extra shares, but under a Dris new shares are issued so investors could benefit from the 30 per cent upfront tax relief, if they hold these additional shares for five further years."

However, you must declare a Dris on your tax return or you will not get the relief – it is not automatic.

Under a Drip, by contrast, the VCT allots you shares that have been already been issued so you do not benefit from 30 per cent income tax relief.

VCT providers that offer a Dris include Albion Ventures, of which the funds target a 6 per cent yield. Colin Low, managing director at chartered financial planners Kingsfleet Wealth, also likes the diversification these funds offer, though says that their growth profile is not as strong as some other VCTs. But some Albion Investments products such as King's Arm Yard VCT have grown strongly over five years, according to Tilney Bestinvest data.

Albion Ventures says that if you invest across their six funds you should receive a dividend every month from one or other of the funds.

Other VCTs open for investment that offer a Dris scheme include the British Smaller Companies VCTs, Mobeus Income & Growth 4 VCT (MIG4) and The Income & Growth VCT (IGV), ProVen Growth & Income VCT (PGOO), Octopus AIM VCT (OOA) and Octopus AIM VCT 2 (OSEC), the Amati VCTs, Octopus Titan VCT (OTV2), Octopus Apollo VCT (OAP3) and Foresight VCT (FTV).

How investors can use VCTs

1. Business sale

John* is client of Kingsfleet Wealth who sold his business three years ago and is working through an earn-out period prior to retirement. "We put some of the funds received into a VCT portfolio - £50,000 out of £500,000 - but with the dividends reinvested initially," says Mr Low. "When John retires this summer we will amend the dividend structure to pay out to him and supplement his pension, Isa, and investment bond income in addition to taking gains from his unwrapped funds. In the meantime he has benefited from tax relief on the reinvested dividends.

"John's aim is to receive £50,000 a year in his bank account and we believe we will be able to manage this with him only paying basic rate tax on his drawdown pension. His VCTs, Isa income, capital gains and some of his pension income are tax free or within his personal allowance, and up to 5 per cent of his investment bond withdrawals are tax deferred."

2. Offsetting taxable income

You might also want to use VCTs to offset taxable income, for example, if you have a chargeable event like encashing an investment bond or with-profits funds. "If you are uncertain about taking your money out of one of these because of the tax, you could take it out and offset this by putting it into a VCT," says Mr Low. "For example, if you are in a with-profits fund and have not had a terminal or annual bonus, you might want to come out. But you should remember that with-profits funds are relatively low risk, while VCTs are high risk."

He used a VCT for a client who was in a very expensive and inflexible offshore investment bond. The client disinvested nearly £353,000 in the summer of 2013 and used two VCTs to offset his chargeable event of £150,000, putting £75,000 into each . "Subsequently he has been able to receive a healthy 5 per cent plus tax free dividend income and reinvest much of his investment in more appropriate funds," explains Mr Low.

The first VCT is now worth £69,299 in value but has so far generated dividends of £6,158. The second VCT is now £76,748 in value and has generated dividends of £5,786.

3. Bonus payment

Mr Woodbridge says that an example of where using VCTs could work is when someone receives a bonus payout – say around £1m - some of which could be allocated to VCTs alongside other investments for their retirement portfolio.

4. Retirement income portfolio

Tilney Bestinvest has provided an illustration of how an investor could use VCTs as part of their retirement planning to generate a yearly tax efficient income in retirement. The investor has:

• £1m Sipp;

• £500,000 Isas (joint names with spouse);

• £400,000 in open-funds and investment trusts (joint names with spouse); and

• £100,000 in VCTs.

The investor could then draw a £76,000 net income as follows:

*4% is a generally sustainable level of withdrawals from a portfolio for those retiring in their 60s

Source: Tilney Bestinvest

Which VCTs?

As you are building your pension pot you could use generalists and reinvest the dividends. Otherwise Alternative Investment Market (AIM) VCTs are focused on high growth companies, but do not typically offer such high yields as generalist VCTs, though this varies from fund to fund. Tilney Bestinvest gives its highest five-star rating to Unicorn AIM VCT (UAV), which is seeking £15m. This is the largest Aim VCT with assets of around £95m. "This is a diverse and mature portfolio containing 47 VCT qualifying holdings, and a number of individual non-qualifying holdings, and will also give investors some exposure to three of Unicorn's open-ended funds," comments Tilney Bestinvest. "The VCT is managed by Chris Hutchinson, who has a strong track record."

If you want something more growth orientated Mr Woodbridge suggests ProVen Growth & Income VCT (PGOO) which is run by respected growth capital manager, Beringea, but says this may not be appropriate for all investors.

If you are using VCTs in retirement to supplement your income you should focus on ones which have a good track record of paying out dividends,. Some generalist VCTs have good long-term track records of doing this. Newer VCTs may pay little or no dividends. Generalists also tend to be broadly diversified across sectors spreading the risk.

Mr Woodbridge suggests the four Mobeus VCTs - Mobeus Income & Growth VCT (MIX), Mobeus Income & Growth 2 VCT (MIG), Mobeus Income & Growth 4 VCT (MIG4) and The Income & Growth VCT (IGV). In recent years these have typically paid dividends of at least 4p, and also have performed well over five years, though Mr Woodbridge adds that there can be no guarantees of future performance and whether this investment is suitable for you will depend on your circumstances.

Tilney Bestinvest also awards its five star rating to British Smaller Companies VCT (BSV) and VCT 2 (BSC), which have sold about half their allocation. "These are established and mature portfolios, investing predominantly in unquoted growing companies, funding management buy-outs and growth capital opportunities," comments Tilney Bestinvest. "A key differentiator of the British Smaller Companies VCTs is their focus on opportunities in the UK regions, made possible by their regional footprint, rather than concentrating all of their time and efforts in London and the South East, where competition is typically much higher. The majority of the VCTs' investments are in management buy-out (MBO) and management buy-in (MBI) opportunities with a much smaller proportion in development capital deals, funding a number of expansionary strategies including exploiting proprietary technologies, developing brands and international expansion."

Open VCT Offers

*This is the last date that cheques will be accepted by Triple Point for allotment in the 2014/15 tax year.

Source: ClubFinance as at 30 January 2015