How venture capital trusts can provide income and growth for pension savers

Venture-capital trusts provide both capital gains and juicy dividends, which makes them the investment vehicle of choice for many pension savers. But they are risky, says David Prosser, so do your homework.

Small, early-stage businesses don’t generate income, right? Well, that might be true as a rule; paying dividends to shareholders is not a priority for most companies as they develop. But venture-capital trusts (VCTs), which invest in such companies, offer some remarkably generous yields. And that makes them the investment vehicle of choice for many pension savers.

VCTs paid out £556m in dividends over the year to the end of March, almost two-thirds more than in the previous 12-month period. This bumper distribution is all the more welcome as there is no income tax to pay on VCTs’ dividends.

Launched almost 30 years ago, VCTs offer investors generous tax breaks in return for providing funding for small and immature businesses. VCT managers build portfolios of investments in these businesses to spread risk, but each investee company must be worth no more than £15m, have no more than 250 employees, and be no more than seven years old.

VCTs: high risk, high reward

These are higher-risk holdings. Such businesses can – and regularly do – fail. But tax benefits provide some protection: not only do the dividends incur no levy, but profits on VCTs are also free of capital-gains tax. In addition, investors get 30% upfront income-tax relief: you can put up to £200,000 into VCTs each tax year, but that maximum investment would cost you only £140,000.

Compare this with private pension saving, where your annual contributions are capped at £40,000 each year. Moreover, there is a lifetime allowance to worry about with pension plans: tax charges kick in once your total savings exceed £1,073,000, including any investment growth. The fact that this allowance has been frozen until at least 2026 means more savers will be caught out. This is why VCTs are now attracting so much attention from pension savers, and not just those who are in the accumulation phase of planning for retirement, where the focus is on building as large a pot as possible. Because many VCTs pay decent dividends, they can be useful at the decumulation stage too, when you’re drawing down money from your savings.

But how do VCTs manage to pay out so much when the early-stage companies they invest in rarely pay any dividends at all? The trick here lies in the way VCT managers structure their support for investee companies. Very often, the investment they make is partly in the form of loan finance, rather than entirely in shares in the business. The investee company’s repayments of this money provide an income stream for the VCT.

This structure comes with the added benefit that lenders to businesses rank ahead of shareholders if the company fails; they have an earlier call on its assets, so this is a less risky type of transaction. But the real advantage here is to turn what would conventionally be an investment orientated towards long-term capital growth into a generator of regular income.

Many VCT managers are now aiming to deliver a yield of around 5% a year – worth 7% if you’re a higher-rate taxpayer – which is why dividends have climbed so steeply in recent times. Pension savers will need to choose carefully, and independent financial advice may prove valuable. VCTs come in many forms, with very different risk profiles and underlying investments. You also need the right fund for your situation. A VCT focused on generating as much yield as possible might not be right if you are still in the accumulation phase of saving. Still, the sector now offers attractive opportunities for both income and capital gains – and for those worried about pension allowances, it has extra potential when it comes to tax efficiency.

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