How much should I invest in VCTs?

David is 58 and a doctor. His wife is 54 and retired, but has not started to draw her pension. Their medical practice earns them about £280,000 a year, which they split between them to be tax-efficient. Their limited company, through which he does some non-NHS work, makes about £80,000 profit per year, which is mostly used for loan repayments on the premises it owns. They do not draw dividends from the company, but declare £2,000 each per year as they are tax-free. David also makes about £20,000 a year before tax from management work.

Their home and holiday home are worth about £650,000 and £100,000, respectively. Both are mortgage-free.

“I intend to retire at age 60 in late March 2022 and maintain our current standard of living, which has typically cost us £100,000 per year after tax,” says David. “From March 2022, our defined-benefit (DB) pensions will provide £58,000 net per year, and this will increase to £70,000 when my wife starts to draw her occupational pension in 2026, £74,000 when I start to draw the state pension in 2029 and £80,000 when my wife starts to draw hers in 2033.

"We could fund the shortfall via dividends from our company, which receives lease payments on the surgery it owns. The company will cease trading when I retire and we plan to sell the premises, which should leave approximately £500,000 in the company accounts. We plan to draw this down as tax-efficient dividends over a period of 15 years. We will initially take £48,000 net per year, and £37,000 when my wife’s taxable income rises as a result of starting to draw her pension.

"I have also invested in venture capital trusts (VCTs) during the past four years and intend to continue. Putting £40,000 into these each year reduces my personal tax bill by £12,000. These will be a convenient way to boost our regular income.

"The VCTs have provided a steady stream of tax-free dividends of around 5 per cent a year, which should amount to £10,000 to £12,000 per year by the time I retire. I am considering building up my VCT holdings to over £350,000 over the next few years. I have sufficient tax liabilities to invest up to £50,000 per year and receive the full 30 per cent relief. And I am able to hold these investments for the long term and understand that their returns are not guaranteed.

"Historically my VCT holdings have not been very volatile. Although they are considered to be high-risk I don’t think that they are a total gamble. I have bought different large VCTs with multiple company holdings to diversify risk, and their level of return makes them difficult to ignore when safer investments are making paltry returns.

"However, many financial advisers suggest that VCTs should not account for more than 10 per cent of an investment portfolio. But how do I value our portfolio, in view of the fact that the largest part of our income will be from index-linked and state-backed pensions?

"We will invest any excess income from these sources into our investment portfolio.

"We have contributed to a self-invested personal pension (Sipp) for my wife in recent years as it has been tax-efficient. We want to invest this fund for growth over the long term because we do not intend to draw from it unless we need to, for example, cover care costs in old age. It is a back-up emergency fund to pass on to our son tax-efficiently as his pension fund. But we will move it into drawdown before my wife reaches age 75 and take the 25 per cent tax-free entitlement.

"I keep enough in easy-access savings to cover our next tax bill and intend to keep £50,000 in NS&I Premium Bonds as an emergency fund for the foreseeable future. My wife is likely to do the same with her pensions tax-free lump sum of £30,000.

"The remainder of our savings are in individual savings accounts (Isas) to which I will continue to contribute surplus cash. When I retire I will receive a pension lump sum of £350,000, which I will invest as tax-efficiently as possible. I also intend to make full contributions to our Isas and my wife’s Sipp for the 2021-22 and 2022-23 tax years. This will leave £100,000 in cash, which I will feed into the Isas over the next couple of years.

"Our Isas and Sipps are mostly invested in equities via a low-cost online broker. Having been stung by the failure of Neil Woodford's former fund, I am keen to keep costs and hassle to a minimum so that I can enjoy my retirement and not have to constantly focus on my investments. Therefore Vanguard LifeStrategy 100% Equity (GB00B41XG308) is the mainstay of our portfolio. But I might add some active funds to try to increase returns.

"The value of our Isas fell 35 per cent last year as a result of Covid-19 and holding Neil Woodford's former fund. But I did not find that unduly worrying and there has been a good recovery since. So I think that we could take a medium-risk approach with the Isas and Sipp, and aim for a total return of 3 per cent above inflation over the long term. We do not need income from these portfolios immediately so I plan to position them for long-term growth, and sell units to generate funds if necessary.

"I wondered whether I need exposure to different assets such as bonds, property and gold, and how to invest the cash within our company before I can move it all into our personal portfolios?"

ONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

Chris Dillow, Investors Chronicle's economist, says:

People who tell you VCTs are high-risk are partly correct. But you are taking the right steps to mitigate these risks. VCTs are perhaps more vulnerable than other funds to manager risk. In the past five years, for example, the best performing generalist VCT has returned 168 per cent while the worst performing one has lost more than 60 per cent. This reflects the fact that the performance of fairly new, small companies is skewed: there are many failures and a few huge successes. Just one or two good or bad investments can make the difference between a VCT doing very well or very badly. You are, however, dealing with this in the right way by diversifying across managers.

A second risk of VCTs is that they and their underlying assets are illiquid, so if you want to sell quickly you might have to do so at a low price. But you’re addressing this the right way by holding cash and premium bonds.

VCTs are also risky in the same way that ordinary equities are: they are vulnerable to falling profits and corporate failures – risks that don’t completely disappear even in economic upturns. But your substantial pension income is, in effect, like a massive holding in bonds – assets that pay a safe income. So you are better placed than many investors to take on economic risk.

And this risk may pay off. The best corporate growth might come from unquoted companies because the need to satisfy shareholders can be an obstacle to expansion. So there’s a good argument for owning VCTs.

But two factors are irrelevant. One is VCTs' tax advantages. In principle, tax breaks cause the price of an asset to be high with the result that pre-tax returns are lower, offsetting the tax break. Also irrelevant is the fact that returns on safe assets are paltry. They are low because the economic outlook is poor and risky – an environment in which corporate assets might do badly.

So, consider how many VCTs you would want to hold if they had no tax breaks and if interest rates were reasonable. That’s how many you should hold. For you, the answer might not be far from what you’re planning.

I don’t think you need more property, or bonds and gold. 

Property would add to the illiquidity of your portfolio without an offsetting benefit. The prospects for the sector will not be great unless the government provides more support for the market, for example by prolonging the stamp duty holiday.

Your pension income means that you effectively have a massive holding in safe assets, so do you need bonds or gold – assets whose only virtue is as insurance against economic risk?

You are right to favour tracker funds as the core of your equity portfolio. But Scottish Mortgage Investment Trust (SMT) and Fundsmith Equity (GB00B41YBW71) have done fantastically well recently, in large part because big tech has soared. Like most investment themes, the big tech trend can’t continue forever, although we cannot predict when it will stop. So can these active funds really pivot successfully away from the sector when the trend stops? This risk justifies some diversification away from them.  

Colin Low, managing director of Kingsfleet Wealth, says:

You have clear objectives in terms of what net income you wish to have, which is of primary importance when financial planning. Your DB pensions will make up the vast majority of that income and knowing that they are index-linked is also very important.

You appear to have the necessary attitude to risk to invest in VCTs, as well as the capacity for loss because of the guaranteed pension income that you will receive. Any suggested limit on how much you should put into VCTs is pretty irrelevant if your own personal circumstances mean that you have the necessary capacity for loss to hold a certain amount of them. They are tax beneficial investment trusts that are reasonably liquid and easily priced, so if you can tolerate their volatility, their tax advantages are incredibly useful. I am working on the basis that your wife can also bear a similar level of risk.

Give some thought to inheritance tax (IHT) issues as these may be complicated by the value of your business when you stop practising. If a business has ceased trading but holds cash, it is unlikely to benefit from business relief so would be brought into the value of your estate. As this is already reasonably significant, consider holding your business premises within your wife’s Sipp. And as you have significant amounts of cash within the business, consider making pension contributions possibly carrying forward previous tax years’ unused allowances, to enable the Sipp to acquire the premises from the company.  This would have to be carried out at full market price, but it would transfer the property into the pension and give you the option of receiving rental income as an alternative income source in the future. Doing this would put more cash into your limited company but offsetting dividend tax from it against arrangements like VCTs is a good way of making the withdrawals as tax-efficient as possible. Property carries liquidity issues, but this does not seem to be a problem with the rest of your portfolio.

However, as you have high earnings levels you may be restricted in terms of what pension contributions you can make. You may also want to investigate deferring pension income to maximise the dividend payments from your limited company and to make these as tax-efficient as possible.

Look into holding qualifying Aim funds within the Isas to make them more IHT-efficient. But remember that they would be significantly more volatile than your current holdings and they have a two-year qualifying period for IHT exemption.