Why consider pension alternatives?
While traditional pensions rightfully remain the core of retirement planning, high fees and slow growth compel some investors to explore alternatives. For some, the more traditional ISA, annuity or property fund may suffice. These add a degree of diversification without getting too adventurous. Those open to a touch more risk may look further afield to private equity in the form of venture capital.
Though riskier, these uncorrelated investments offer a range of tax reliefs which make them particularly attractive to investors looking for tax efficiency, and the potential for significant returns. Most venture capital investors go through one of three main schemes, the Seed Enterprise Investment Scheme (SEIS), the Enterprise Investment Scheme (EIS, and Venture Capital Trusts (VCTs).
Diversifying outside of a traditional pension and building a portfolio of alternative investments can be an excellent way to see a greater rate of growth with fewer caps and limitations, on top of other benefits – capital gains tax relief comes in very handy if you’re selling a second home, and exemption of assets from inheritance tax speaks for itself – though it is important to understand the risks involved before investing.
Below we take a look at some of the investments one may want to consider alongside a traditional pension.
What are the most common alternatives to pensions?
An Individual Savings Account (ISA) provides a tax-efficient way for individuals to save and invest money. ISAs come in multiple forms, including cash ISAs and stocks and shares ISAs. Returns generated within the account are typically exempt from income tax and capital gains tax.
An annuity is an insurance contract that promises to pay an investor's regular income either immediately or in the future. Investors can purchase an annuity with a lump sum or over a set period. There are three main types of annuity. These are fixed, variable and indexed. Each has a level of risk and payout potential. The interest payments received by the investor are taxed at regular income rates, not longer-term capital gains rates.
Enterprise Investment Scheme
EIS investments and EIS funds allow investors to invest in early-stage businesses that have the potential to undergo significant growth and deliver very attractive return multiples to investors.
On top of the promise of returns, this scheme provides generous tax reliefs to incentivise participation in funding innovation and job creation, and to offset the risk to the investor. Diversification is a key strategy when investing in startups as many of the underlying companies will fail. Given the stage of the companies there is a high level of risk involved with investing in them and the investments are highly illiquid.
Venture Capital Trust
A Venture Capital Trust (VCT) is a tax-advantaged investment scheme designed to encourage investment in small, high-risk, and often early-stage companies. VCTs are publicly traded companies that invest in a portfolio of small businesses, providing them with crucial capital for growth. In return, investors receive tax incentives, including income tax relief on the amount invested and tax-free dividends.
Real Estate Investment Trust
Real estate can be a good way to generate income and capital appreciation over time. However, it is important to note that real estate is an illiquid asset class and requires active management. That is why many investors opt for a Real Estate Investment Trust. These are listed companies that invest in, operate or finance income-producing properties. REITs give investors some of the upside of property investing without the hassle of having to manage the properties themselves. REITs, must distribute at least 90 percent of their taxable income to shareholders as dividends.
A commodity is a basic good used in commerce, often as input in the production of other goods or services. Investors can buy and sell commodities directly or via derivatives. Commodities are often categorised as hard (energy and metal products) or soft (mostly agricultural goods). Commodities are often used to hedge against inflation or, in the case of gold, silver and other metals, held for long-term growth.
How should an investor evaluate supplementary investments for retirement planning?
When choosing any investment, and in particular those that are considered to be alternative, it is important to do the following:
Define your investment goals. Planning for your retirement starts with understanding what you want to do and how much money you will need to be able to do it. Start from what you have and work out what return you need to get there.
Identify the return potential. Alternative investments have the potential to generate higher returns than traditional investments. However, it is important to remember that there is no guarantee of returns and some assets are riskier than others.
Consider your risk tolerance. On their own alternative investments are generally riskier than traditional investments. That is why you must first be comfortable with that risk and then work to rebalance your portfolio accordingly..
Research the correlation between the assets. To help balance a portfolio an investor must understand the level of correlation between different asset classes. For example, venture capital and real estate have a low correlation with stocks and bonds showing that they are largely independent in their movements.
Understand portfolio liquidity. Liquidity is how easily an asset can be bought or sold. Stocks and bonds are fairly liquid. Property is less liquid, and venture capital is nearly illiquid (returns coming when the fund's portfolio companies are sold or listed on a stock exchange).
Review the fees. Alternative investments typically have higher fees than traditional investments. It is important to understand the fees involved before investing as they can eat into returns.
Investigate potential tax reliefs.
Many of the UK’s venture capital schemes, EIS, SEIS, and VCTs offer investors incentives, in the form of tax reliefs, for taking on the risk of investing in early-stage companies. These may include income tax relief, capital gains deferral, loss relief, and inheritance tax relief.
The additional tax reliefs offered by EIS funds
The tax benefits on offer are very generous, but before investing, investors should ensure they qualify to receive the relief. The fundamental requirements are that an investor is a UK taxpayer, and is not closely affiliated with the companies in which he or she invests.
Qualifying investors can expect to receive the following tax reliefs:
- 30% income tax relief on the amount invested into EIS-qualifying companies.
- Capital gains tax can be deferred by rolling the whole of the capital gain through EIS.
- If an investment goes bust investors may receive additional loss relief.
- Tax-free capital gains on investments that are held for a minimum of three years.
- Investments that are held for a minimum of two years qualify for inheritance tax relief.
If you are uncertain if you qualify or if you require further help we advise you to speak to a professional accountant or advisor.
The impact of including the Access EIS fund in your portfolio
Access is a venture capital fund that offers investors EIS tax relief whilst spreading the investment over a portfolio of highly selective startups.
Our research (link) found that the UK venture market has a low correlation, 7% to be exact, with publicly traded markets. As read above, including uncorrelated investments in a broader portfolio can increase diversification and reduce volatility of the portfolio as a whole.
Further, research by Hardman & Co (link) found that including an optimal proportion of venture capital can have a positive impact on portfolio returns while maintaining, or reducing, the overall portfolio risk.
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So, are there good alternatives to pensions? Certainly, although across the board they should supplement rather than replace a traditional pension. Where a traditional pension can give you slow but consistent growth, supplementary investments can improve your overall returns and risk profile.
If you would like to read more about Alternative Investments and their role in a broader portfolio we found these articles and white papers insightful:
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