Do Savings Eroding Cash ISAs Still Have a Place in a Good Investment Strategy?

The rock bottom interest rates in place since the international financial crisis of 2008/09 have called into serious question the long-held maxim of ‘cash is King’.

In the UK, the base interest rate set by the Bank of England has been at 0.5% or lower since March 2009. To put that in context, the base interest rate varied between 4% and 5.75% over the period between the turn of the Century and 2008.

The central bank has used low-interest rates as part of its fiscal stimulus strategy to encourage investment and keep an economy still considered fragile moving ahead. Most agree that has largely worked and low-interest rates have kept business and personal borrowing and investment on track, boosting the private sector economy and housing market.

However, where borrowers and spenders have reaped rewards savers have suffered. For some time now the interest rate paid by banks on cash holdings has been behind inflation. This means that the accepted wisdom that putting cash into the bank will allow it to slowly grow through accrued interest has ceased to hold true.

When then Chancellor Gordon Brown introduced Cash ISAs in 1999, a tax-free interest rate of around 7.5% made the new savings product hugely attractive. That, unfortunately, is no longer the case.

Interest rates offered on cash savings have continued to fall in recent years while the inflation rate has ticked up.

While the average 1.5% interest paid on Cash ISA holdings in 2012 seemed miserly against the historical backdrop, 5 years on and midway through 2017, that has dropped to 0.39%. At the same time, the inflation rate, measured by the change in prices to a basket of different everyday goods and services, has moved sharply up, hitting 2.9% in June of this year.

All of this adds up to the reality that putting funds into a Cash ISA at present, or keeping them there, means an erosion of purchasing power or real value.

Do cash ISAs have a place in a good investment strategy

Source: Hargreaves Lansdown

 

Why Does Anyone Still Have a Cash ISA?

Presumably aware that putting or keeping savings in a Cash ISA essentially means losing money in 2017, and little realistic hope of that changing anytime soon, the question has to be asked why so many people still do it?

The advantage of cash savings over risk-based investments is still the perception of a lack of risk. The thought process is ‘I might lose a couple of % per annum to inflation if I hold cash but if the stock market tanks I could lose a lot more through holding funds or shares’.

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There is a degree of risk in any investment product and history informs us that the feared scenario of the Cash ISA saver outlined by that statement could become a reality. Financial markets are cyclical and they do slump, as we saw in 2008/09.

Do Cash ISAs Still Have a Role?

History also demonstrates that when financial markets do crash, given time they have always, at least until now, subsequently recovered and eventually reach new heights.

As such, there is still a place for Cash ISAs, even if they mean losing some purchasing power. Having a chunk of savings in cash has two advantages if markets take a downturn:

  • If savings need to be used before markets recover, cash holdings can be used and investments held until their value has recovered.
  • Cash holdings can be used to buy investments at bargain prices at the bottom of a market cycle.

The accepted guidelines around what percentage of savings it is advisable to keep in cash varies depending upon personal circumstances and also external conditions such as current interest rates. However, most financial advisors suggest 10% to 20% held in cash as a rule of thumb.

If retirement is less than 10 years away then the percentage of savings held in cash being towards the higher end of this range makes sense. A market slump might mean that savings have to be drawn from before a recovery has time to take place and cash holdings will avoid the necessity to cash in devalued assets at a loss.

If savings are not earmarked for use in the next several years, in most cases it will make more sense to keep less cash, accept a reasonable level of risk and chase inflation-beating positive returns in the meanwhile.

In answer to the question posed: while low-interest rates and rising inflation have significantly reduced the attractiveness of Cash ISAs, they do still have a role to play.

However, that may well be a significantly reduced role, particularly for anyone not intending to dip into their savings in the next decade.

Moderate risk-profile investment products such as equities, funds and higher-yielding bonds, such as corporate bonds, should, in most circumstances form the bulk of savings for anyone who wants to avoid erosion of value while still keeping a cash cushion to protect against a rainy day.

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Last updated: June 27th, 2017

John Adam

John Adam co-founded iNVEZZ.com, a news, analysis and comparison portal for retail investors. iNVEZZ was acquired by Investoo in 2017.

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