At the present time, the best rate available on a Cash ISA is around 1.5%. While that may sound relatively high compared to previous years, it continues to create a significant opportunity cost versus other assets.
While in the short run this may not make a major difference to an individual’s financial future, repeated investment in a Cash ISA could cause financial challenges in the long run. With the purchasing power of amounts invested likely to decline, individuals utilising these products may find their finances to be in worse shape than they had expected in the long run.
Purchasing power
Over the course of a lifetime, inflation can have a significant impact on an individual’s finances. It gradually eats away at the spending power of capital so that £1 in 40 years’ time buys far less in goods and services than it does today. When it comes to retirement saving, therefore, it is important to ensure that there is a good chance that the returns from an investment will at least be ahead of inflation in order to protect its purchasing power when it is needed later on.
The problem with Cash ISAs is that they currently offer a return which is lower than inflation. Over time, this means that the spending power of capital within a Cash ISA could deteriorate. And with the first £1,000 of interest income in savings accounts now not being taxable, there is little to be gained in terms of tax efficiency from having a Cash ISA either.
Interest rates
Of course, interest rates are currently at a low level compared to their track record. This means that they may move significantly higher over the long run, and the returns on a Cash ISA could do likewise.
The problem, though, is that interest rates are closely linked to inflation. In other words, in order for there to be a sustained rise in interest rates over a long period, inflation is likely to have to move higher. This will prompt action by rate-setters, and could mean that interest rates are always one step behind inflation. Over the long run, this could translate into continuous negative real returns from Cash ISAs.
Simple solution
A simple solution for individuals who are looking to save each month and generate a positive real return is index tracker funds. They significantly reduce overall risk through being well-diversified. They also have exceptionally low costs, which means that they are likely to be accessible to a wide range of individuals.
Although tracker funds are riskier than a Cash ISA, they can offer inflation-beating returns. The FTSE 250, for example, has delivered a total return of over 9% per annum over the last 20 years. That’s significantly higher than inflation, and could make a real impact on overall returns in the long run.
And for individuals who wish to take more risk with the potential for higher returns, buying shares in companies could be a worthwhile means of generating higher wealth over the long run.