This is “year one” for the baby boomer generation retirees and over the next 12 years, a sizeable proportion of the UK’s population will be retiring. For anyone in the 53 to 65 year age bracket, retirement planning is a priority and retirement income is an issue.
The average single annuity rate for a 65-year-old is presently around 6.72 per cent. With life expectancies for baby boomers exceeding those of the generation that preceded them and with bond yields falling, annuity rates, despite a rise in the three months to March 2011, are expected to fall.
Further concerns for pension income include inflationary increases that eat into the value of any income received as well as recent changes to pension regulations that include limits to the size of a pension pot.
Anyone approaching retirement will be looking to maximise their pension income and in our conversations with advisers and clients, the message is clear investors want predictable levels of attractive income.
Typically, advisers would look to equity income or bond funds to provide additional income but yields are presently low and in the case of equity income funds, investing across a number of equity income funds, which overlap on many stocks, reduces portfolio diversification.
In the 2010 annual shareholder survey, we found that one in four of our share-holders viewed their VCT holding as a pension top-up.
With 78 per cent of our shareholders owning VCTs managed by other companies, this is a fairly representative sample of the VCT shareholder universe.
VCT investors tend to be high earners with substantial savings and investment portfolios a profile that will no doubt resonate with many of Retirement Strategy’s readers. For clients that are not presently invested in VCTs and who are considering retirement income strategies, what benefits can VCTs offer them as a pension top-up?
First, it should be stated that VCTs are not low-risk investments and the question of risk and suitability will differ from investor to investor. This is a discussion for advisers to have with their clients. Certainly, we would not purport that VCTs are suitable for everyone.
However, VCTs do offer investors a number of benefits that make them suitable for consideration as a pension top-up, including an attractive tax-free income stream and portfolio diversification.
The diversification benefits of VCTs hail from their investments in unquoted companies but, equally, their portfolios tend to be highly diversified, with up to 50 individual holdings.
VCTs tend to be either generalist or specialist. Generalist VCTs tend to offer further diversification benefits to investors because they invest across sectors but when an investor is seeking income,it is the dividend stream that will prove most attractive.
As table one illustrates, VCTs can offer very attractive levels of income, which are boosted by the tax benefits they offer. While investment exits are very valuable, they are not the only mechanism within a fund by which a VCT manager gener-ates returns for investors. Many VCT managers structure their investments specifically to generate income for the fund to create a powerful revenue stream.If loan stock continues to deliver returns and the company is profitable, there is no pressure to sell.
For example, at Albion, we have held a number of investments for over 10 years and intend to continue to hold them. Furthermore, VCTs pay no tax on realised investment gains and these can be distributed directly to shareholders following each realisation.
The ability of the fund management team to manage income and gains within the fund and distribute steady, sustainable dividends is valuable for investors seeking pension top-up income. Retaining profits to distribute over time, therein smoothing out any lumps, provides this consistency. Steady dividends also support the share price as dividends are also tax-free and are therefore attractive as income stocks, since most VCT shares trade at a discount and can bought cheaply relative to the dividend yield.
One drawback to VCTs for income is that it does take time to show investors a decent return. Typically, a VCT portfolio takes three to four years to invest and then another three to start to mature. A new VCT would usually take around five years to start paying an attractive dividend to shareholders. This is not the case for top-ups to existing VCTs.
One of the interesting features about the VCT offers available in the 2010/2011 tax year was the number of top-ups. A top-up is a new share issue to an existing VCT portfolio and a linked top-up spreads a subscription across a number of funds. In Albion’s linked top-up offer, for example, there are 55 investments spread across seven VCTs.
Many of these linked top-ups, including our own, have extended their opening period beyond the April 5 budget deadline and remain open to investors.
The reason a number of VCT managers are offering linked top-ups relates to risk and income. Investing in a number of funds reduces risk and as the funds mature, the companies within the fund will inevitably be at different stages of development, with some new and some older investments.
Older investments tend to be less volatile and more cash-generative than more recent investments. For investors, the earnings stability of an investee company allows the manager to recoup consistent cash and, rather pleasantly for the shareholder, older, bigger companies tend to be more profitable.
Last but not least, the tax treatment of VCTs is straightforward and therefore also beneficial to high earners. By way of an example, and as table two illustrates, Mr Smart, an investor aged 56 earning £180,000 a year, wants to make an investment of £200,000 in a tax year.
If Mr Smart chooses to buy a gross amount of £200,000 of new shares in a VCT or a VCT top-up offering, he will receive cash tax relief of £60,000, making a net investment of £140,000 within the fund.
He pays no tax on any dividends he receives and retains the ability to wind up his investment after five years without paying tax on any gains he may have made.
Furthermore, the capital he gets back is his to do with as he likes and while there is a £200,000 a year limit on VCT investing, he can own as many VCT shares as he likes.
Compare this investment to a similar investment by Mr Smart in his pension. He places a net investment of £140,000 in his pension, which is increased to £175,000 as a gross contribution, assuming, of course, that he has paid sufficient income tax.
The total amount that Mr Smart can invest is capped and any income that he can receive from his pension will be taxed.
Mr Smart, assuming he does not exceed his lifetime allowance, is entitled to 25 per cent of his eventual pension as tax-free cash but the rest of his pension fund will be used to buy an annuity.
The income from the annuity will also be taxed at his marginal rate of income tax, which could well be 40 per cent or more.
VCTs, as we noted earlier, are not suitable for all investors. However, they should be considered by higher-rate taxpayers as they approach retirement and look at the options available to them to maximise their income in retirement.