Wednesday 25 September 2019 6:59 am

Adventure capital: Young firms offer strong returns, so why aren't pensions invested?

Are you taking on enough risk? Because a common concern among money experts is that pension savers, particularly those who won’t reach retirement age for decades, are not. 

If you have opted for your pension provider’s default fund, it’s highly likely that you will be invested in companies that are well-established, but only give you a small return. 

According to a report from the British Business Bank (BBB) and consultancy Oliver Wyman, published today, pension pots could be missing out on higher returns because they have no allocation to higher risk venture capital or growth equity funds. These funds invest in early-stage companies with lots of growth potential.

The government-owned bank has advised that allocating five per cent of your savings to venture capital could be particularly beneficial for younger savers. According to its research, someone who starts saving for retirement when they are 22 could increase their defined contribution (DC) pension pot by seven to 12 per cent over the course of their working life (assuming they retire at 67), compared to being invested in a provider’s default strategy.

And while the potential rewards are higher the younger you are, there is also a noticeable difference for older savers. For example, a 35-year-old with £25,000 currently invested in retirement savings could see a six to 10 per cent increase in their savings when they retire, while a 45-year-old with a £50,000 pension pot could see a six to seven per cent increase.

Rather than making a quick profit, venture capital and growth equity funds invest in companies that can’t be traded on the stock exchange and are harder to sell (the investment is normally crystalised when the firm is listed on the stock market or taken over). The long-term and illiquid nature of these types of investment makes them well-suited to pensions. 

There is also a prolific amount of growth coming from so-called unicorn companies – that is, those fast-growing firms valued at £1bn or more.

The BBB report points out that equity investment into UK SMEs grew to £6.7bn last year, up from £3.9bn in 2016. Much of this has been channelled into tech, life sciences, or intellectual property companies – think Revolut, Darktrace, Deliveroo, Monzo, Skyscanner, and OakNorth. 

And yet, despite the fact that many young people are customers of these innovative companies, they are currently unable to invest their retirement savings in them. Instead, pensions tend to be heavily allocated to mature, low-growth companies that are listed on a stock exchange.

To VC or not to VC?

So what is holding venture capital back from being held in DC pension funds? 

The main problem is that they are characterised as too high risk and complex to be suitable for the majority of DC investors. And Lorna Blyth from Royal London warns that they can also come with expensive fees, which would make it impossible for DC schemes to meet the regulator’s charge cap on default pension funds.

The BBB admits that there are challenges to encouraging the use of such assets in DC pensions. In order to tackle these issues, Catherine Lewis La Torre, chief executive of British Patient Capital, told City A.M. that improving the quality and availability of industry-level data on the asset class will make these investments viable on a greater scale. 

“This data forms an important tool for the advisory community, trade bodies and others in helping scheme sponsors understand the value and potential of the asset class,” she says.

The BBB report suggests that venture capital fund managers would need to reduce their fees into order for them to be suitable for use in DC pensions. The bank also recommends that venture capital managers work together to create pooled investment vehicles to help DC schemes invest at scale.

Structurally, there is an appeal to having venture capital within investments that are held for a long time. 

However, Guy Foster, head of research at Brewin Dolphin, warns that a lot of money can end up chasing a finite number of attractive investment opportunities. “This has been evident in the over-valuation of certain companies once they reach, or get close to, their flotation,” he says. 

And there are other reasons for wariness among the financial planning community.

Keith Churchouse, director of Chapters Financial, argues that while the prospective returns may appear to be attractive, the risk of default is invariably higher than traditional types of pension investments. 

“Many investors are not prepared to take this potential risk, or do so with only a small percentage of their overall fund values,” he warns. “It’s an interesting opportunity, but only for the few, and in limited amounts.”

But Ben Yearsley from Shore Financial Planning is positive about the idea of investing in startups via your pension, saying that investors generally take far too low a risk with their long-term savings. “If you are in your twenties and investing in your pension, why would you not take the highest growth option possible?”

Savers do have to be aware that a high proportion of venture capital companies will fail. However, if you are invested in a pool of venture capital firms, the gains should outweigh the losses over time. 

Saving grace

According to the BBB, venture capital has delivered an average return net of fees that is seven per cent higher a year than the return seen in public equity markets – since 1970, venture capital has returned 18 per cent annually, compared to 11 per cent for the MSCI World Equity Index.

So maybe now is the time to inject some of that growth into pensions.

Auto-enrolment is expected to push workplace DC pension schemes to the £1 trillion mark over the next 10 years. While this is positive, the worry is that vast swathes of people are not being given access to the level of risk they need to live comfortably in retirement.

With DC schemes becoming an increasingly important source of capital, a shift to higher risk investments has an opportunity to benefit both pension savers and young British companies.