At the present time, obtaining a return above 1.5% on a cash ISA is challenging. While a return of 1.5% may be above levels offered by providers in recent years, it continues to be poor when compared to the returns of other assets.
Although cash ISAs have proved popular among investors in recent years, the reality is that tax changes and low interest rates have made them far less appealing. For individuals who have a long-term time horizon, it may be possible to generate significantly better returns by investing in a diverse portfolio of shares.
Unappealing product
Tax changes and low interest rates mean that the return on a cash ISA versus the return on a bog-standard savings account is not much different. In the past, the tax paid on interest income meant that the tax-avoiding appeal of a cash ISA was high. However, with the first £1,000 of interest income per tax year now not subject to income tax, it means that, for most individuals, there’s little benefit to having a cash ISA.
This situation has been exacerbated by low interest rates. Assuming a rate of 1.5% is available on a savings account, an individual would need to have savings of around £67,000 for it to be worth moving the money into a cash ISA. And since this would amount to several years’ worth of ISA allowances, it doesn’t seem to be a worthwhile or practical strategy.
Improving returns?
The prospects for UK interest rates are, of course, difficult to accurately predict. Brexit could cause a delay in their rise, or a weak pound could prompt the Bank of England to adopt an increasingly hawkish strategy. Even if interest rates do rise over the medium term, they’re unlikely to increase at a rapid rate. This may mean that inflation remains ahead of the return on a cash ISA for a number of years.
The effect of interest rates on cash balances being below inflation may not be felt by individuals in the short run. Over time, though, it gradually reduces their purchasing power and makes cash savings an inefficient use of capital.
Long-term potential
In contrast, the returns on investments in the stock market are relatively appealing. On a total return basis, for example, the FTSE 250 has recorded annualised growth of over 9% during the last two decades. This would mean that an investment of £1,000 made in early 1999 would now be worth around £5,900. An investment of £1,000 in a cash ISA, which records an annual return of 1.5%, would be worth around £1,350 in 20 years’ time.
While there’s no guarantee that the FTSE 250 will record a 9%+ return per annum over the next 20 years, history shows there appears to be a good chance that it will beat the return on a cash ISA. As such, now could be a good time to consider switching from cash to shares.