This month, the Institute of Directors (IoD) called on the government to make it easier for business owners to invest their pension into their own business. Some voices, most notably from within the pensions industry, have condemned this as too high a risk. Here I look at the risk of a pension-led investment into a business compared to other sources of funding.
The ability for certain types of pension to provide financial support to SME owners is well established and not in dispute. SSASs (Small Self-Administered (pension) Schemes) have been lending money to their parent company since 1979. SIPPs (Self Invested Personal Pensions), although slightly different in method, have been able to do much the same since the 1990s.
Why do a minority of commentators continually decry the practice of Pension-led funding as either illegal, dubious or just insanely risky
Over this time hundreds of millions of pounds have been injected into UK SMEs, creating thousands of jobs, generating huge amounts of additional payroll and corporate tax revenues for the exchequer.
So why do a minority of commentators continually decry the practice of pension-led funding as either illegal (simply not true), dubious (ditto) or just insanely risky?
If we dismiss the first two as simply a lack of knowledge, we are left with risk, which definitely does exist, and merits further examination.
Risk is both relative and subjective
I would argue that an individual who has been running a successful business over a long period of time would have a completely different approach to, and understanding of, commercial risk than, say, a local council employee. The council employee’s risk lies outside of their control. Redundancy, a reduction in hours or pension benefits.
Successfully avoiding these employment pitfalls results in (hopefully) a state of financial security underpinned by pension scheme membership, personal savings and home ownership. These are, in most cases, the three pillars that support an individual’s lifestyle after retirement.
Based on the above employee profile it’s pretty easy to see why the idea of investing some of his or her pension into a small business would seem to be extremely foolhardy. But this, of course, is where the difference lies, and where, in many cases, commentators on the subject expose their lack of understanding of small business owners.
You see, a business owner has a completely different perspective when it comes to achieving financial security. In a recent survey of Forum of Private Business members, over 50 percent of respondents stated that their business is their pension, and the asset most likely to provide them with financial security in retirement.
It is also worth pointing out that by its very nature business involves risk. ‘Speculate to accumulate’, the entrepreneur’s adage par excellence is quoted for a reason. Business owners accept risk daily and learn to control and mitigate, to offset and to persevere to create the outcome they desire.
They are taking responsibility for the outcome of all their transactions and their own long-term financial security. Telling an entrepreneur not to take a risk is about as sensible as telling a gazelle not to run. It’s what they do, and they are good at it.
Risk is also relative, however. If one accepts that most businesses need funding to aid growth, the money must come from somewhere, and they all come with some risk.
Handouts from friends or family
Starting with the ‘friends and family’ route. All this does is transfer risk from the business owner to some close acquaintance or family member.
The actual amount of risk is no less, indeed if you were to consider the added emotional and personal damage, this is a pretty high-risk approach by all concerned. Add to this that friends and family seldom test the validity of a business model or take adequate legal security, and you have an amateurish recipe for disaster.
So, it’s the bank then?
That’s what banks are there for, right? Yes, a bank will lend to a business, but only when every last bit of risk has been squeezed out of the proposition.
They will want a robust business model with a strong track record, a squeaky credit history, and, most importantly, real, tangible security.
We now have an additional layer of risk: that your supporting lender continues to have an appetite to lend to you. A withdrawal of such support can be catastrophic
For many small businesses that don’t have a balance sheet propped up by property, the only available security is the owner’s home. In most cases a charge is taken over this asset, together with a personal guarantee from our entrepreneur.
Far from reducing risk, this significantly increases it. We now have an additional layer of risk - that your supporting lender (the bank) continues to have an appetite to lend to you. A withdrawal of such support can be catastrophic.
Of course, the consequences of failure to repay bank debts don’t stop there. In most cases the business will fold, destroying its asset value, the individual will face personal bankruptcy and the family home might be lost. Devastating for all concerned, and about as risky as it gets.
Where does using your pension to fund the business fit in the risk spectrum?
We need to look at each individual business and its owner’s track record, their risk profile, capacity for loss and the available security.
Only if these all stack up should they proceed and we haven’t really touched on the main issue here. In the vast majority of cases, the business owner’s pension fund will not provide a lifestyle comparable to the one they enjoy whilst working.
The only chance of real financial security lies in creating a genuinely saleable business. Failing to invest in it is the biggest risk of all
In these circumstances, I would argue that the only chance of real financial security lies in creating a genuinely saleable business. Failing to invest in it is the biggest risk of all. In addition, there is no third-party exposure as a pension-led funding user wouldn’t choose to pull the plug on their own business. In reality, no bank or third-party debt really does equal less risk.
So yes, it may sound risky, using some of your pension to support your business, but failing to understand the whole picture and process is far riskier.
Author | Adam Tavener, Chairman of Clifton Asset Management and Alternative Business Funding (ABF)