Cash ISAs may be popular with UK savers but they won’t make anyone rich in a hurry. In fact, last year, returns were the worst yet for those holding this tax-efficient account. Today, I’ll cover what I believe is a far better way of generating passive income.
Cash ISAs: why they won’t make me money
The best instant access Cash ISA pays just 0.6%, according to Moneysavingexpert.com. That’s right – the best account! In other words, anyone with this account and £20,000 in savings (the annual ISA allowance) will make just £120 in passive income a year.
To get higher interest rates, investors need to move towards accounts that tie up their money for a certain period of time. To get a fixed 1.15% rate, for example, I’d need to lock up my cash for five years. That’s an awfully long wait for such a miserly return.
It gets worse. The longer cash is held at these rates, the greater its value will likely be eroded by inflation over time.
Perhaps most crucially, saving into a Cash ISA isn’t even necessary for most people these days. Thanks to the Personal Savings Allowance (PSA), we can earn up to £1,000 in interest every year without needing to hand anything back to the taxman.
I’d buy dividend stocks for passive income instead
If I’m wanting to generate truly passive income, there’s only one place I’d head. The stock market. My strategy wouldn’t be complex either. Simply buy solid dividend-paying shares and watch the money periodically drip into my account.
Of course, this simplicity doesn’t mean anything is guaranteed. Last year showed that dividends are often the first things to be sacrificed in grim times. Nevertheless, there are ways of mitigating this risk.
Not placing all my eggs in one basket in one example. In other words, I should hold enough stocks so that the overall passive income stream isn’t too badly affected if one, two or a few stop paying out. I’d also hold stocks in different sectors, such as pharmaceuticals, utilities and consumer goods, rather than just one part of the market.
Go for growth
The best dividend payers also tend to regularly increase the amount of cash they return to shareholders. This, for me, is more important than the size of the cash return. A company that promises a modest but growing dividend is indicative of a healthy business underlying it. One offering a high but stagnant payout is indicative of a company treading water.
Investors don’t need to look hard for these dividend stars. In the FTSE 100, there’s consumer goods giant Unilever, drinks king Diageo and power provider National Grid. In the FTSE 250, there’s veterinary product supplier Dechra Pharmaceuticals, software provider Spectris and flow control company Rotork. Further down the market spectrum, there’s Vimto-maker Nichols and investment manager Brooks Macdonald. All these firms have consistently grown their dividends over the years. Many have hiked their payouts every year for the last decade.
This is no accident. The best dividend payers tend to be those with strong business models and competitive advantages. They produce and/or supply goods or services that are in regular demand. Their balance sheets are robust enough to withstand the occasional, inevitable setback.
These are the stocks that are very likely to provide a better income stream than the wealth-killing Cash ISA.