Cash Savings Vehicle

It’s all about the money……

Most people hold cash. However, their approach to cash seems irrational. They do not approach it in the same way that they would when investing in shares (or funds).

Cash has always been the most attractive asset class. The reasons are simple, the capital sum never decreases and the ‘growth’ or ‘income’ is known. The FCA estimates that 82% of UK consumers hold some form of savings account.

Savers were rewarded with rates of between 4 and 5% prior to the 2008 crisis, and going back to 1999 it was over 6%. The challenge is that for the last 6 years plus the average ISA has been paying around 1%, and easy access accounts pay as low as 0.3% p.a.

Those using cash as a means of providing income have for some time faced a stark choice of either taking a lower income or topping up the income by using capital. Those using capital to top up their income know that it won’t last forever, and there is a gradual acceptance that interest rates will remain low for several years and saving rates are not likely to rise significantly.

So what are the options?

Why hold cash?

Most people hold cash. However, their approach to cash seems irrational. They do not approach it in the same way that they would when investing in shares (or funds).

The FCA has carried out significant research in this area and it shows three interesting facts – firstly 34% of savers do not check their interest rate, secondly the vast majority of savers do not actively shop around for the best rates and thirdly only a small minority are classed as ‘rate chasers’(searching out the best rates).

There are reasons for this and part of it is because cash can be held for several different purposes. For example, where there is a known expenditure like a tax bill then holding cash (against investing in shares /funds) makes sense, because the money is needed for a specific event and the loss of all or some of that capital would create potential hardship.

Another example would be to provide an income, although this is becoming increasingly unrealistic! Perhaps 20 or 30 years ago when life expectancy was 5 to 10 years after retirement and saving rates were in excess of 5% p.a. it made sense, now this is questionable.

So some of the challenges include:

  1. Life expectancy – assuming someone retires at 65, living for the next 15 to 20 years is not unexpected, and therefore capital needs to last longer
  2. Low inflation / low interest rates – interest rates will remain low for longer, and therefore saving rates will do the same. The inflation target is 2% and therefore savings rates are unlikely to significantly outperform inflation going forward (if at all)
  3. Income – low rates mean that saving rates cannot realistically be used to provide income without using capital

Cash may be perceived as being a risk free asset but if it is not managed in the right way it can increase the risk.

Managing cash

From the FCA study it is clear that people do not manage their cash and the rush for the pensioner bonds displayed irrational purchasing.

On the surface there appear good reasons for it because the headline rates were 4% and 2.80% but actually before making any investment, the question of suitability is raised.

Some facts to consider:

  1. The maximum investment is £10,000 (£20,000 for a couple)
  2. The net interest is 2.40% for a 40% tax payer and 3.2% for a basic rate tax payer (on 4%) and 1.68% and 2.24% (on 2.80%)
  3. Capital is locked away for 3 years and 1 year, the interest cannot be taken without penalties being applied (so this will not appeal to those seeking income)

If we go back to the FCA study, the average holding in savings is around £6,000 and the most popular account is ‘easy access.’ This tells us two things: firstly most people don’t have much cash and secondly they want to be able to get their hands on it.

It is fair to assume that because people are accepting of the rate they get, this is driven either by the ability to access money when they want it, or they are not aware of what they are getting and don’t care!!

The fact is that although the pensioner bonds have caused hysteria with people desperate to invest in one, the same questions should apply before they rush in:

  1. What do I need the capital for – income, growth or a combination of the two?
  2. Do I need access to the capital, and if so when?
  3. What level of risk am I prepared to take?

The list of questions is not exhaustive but they help to provide an indication as to whether any savings account is the right one.

Cash is the only option

If the average cash savings is £6,000 and this is the only money someone has in retirement (other than pension income) then the risk they are prepared to take on the capital is likely to be minimal, and it is unlikely that they will want that money locked away for any period of time.

For income seekers many fixed rate cash bonds (including the pensioner bond) do not allow access to the savings rate until the policy matures (without penalties). If this is three years then this is a long time to wait for the income!

The pensioner bond has also highlighted the new way of achieving higher rates – in many cases the best rates come with a cap on the maximum that can be invested, which means to achieve this rate cash investors need to spread their money around. And more importantly, be actively monitoring the rates.

The FCA study showed that many of the headline grapping promotional offers revert to poor rates at the end of the promotion. Ironically many savers do not move the money at the end of the plan!

To show how complex the market is we took a look at what is available:

  1. The best ISA rates today vary between 1.7% for a one year bond (equivalent to 2.83% gross for a higher rate tax payer, 2.13% for a basic rate tax payer) and 2.5% for a five year bond (equivalent to 4.17% gross for a higher rate tax payer, 3.5% for a basic rate tax payer) for a 5 year bond
  2. The maximum investment into an ISA is £15,000 but investors can move other cash ISAS across), and it can be doubled with spouses
  3. Having current accounts can be a route to higher savings up to 4% but often the amount is capped. There is an ISA paying 3% via this route (equivalent to 5.0% gross for a higher rate tax payer, 3.75% for a basic rate tax payer)
  4. The rates change almost daily, only a couple of weeks ago the higher rates were around 2.6%. So regularly checking the rates is important

The point is that the pensioner bond may be offering a headline grabbing rate, but like any investment care needs to be taken because it may not turn out to be good as it first appears.

Is there another option

For those who are prepared to put funds away for three years (or more) they could also consider taking on more risk, as generally longer investment horizons smooth volatility.

A good example is if I invested £100,000 on 1 January 2007, and did not touch it until 31 December 2014 what would I get in return?

Investing in the Money Market Index provides a good benchmark of what cash would have returned, assuming a cash investor left the money on the lowest rate. Over this period assuming the capital was left untouched the return was 1.06% p.a. This gives a total return of £108,845.86 (capital of £100,000 plus £8,845.86 interest).

If we took a simple ETF tracking the UK dividend payers (iShares UK Dividend ETF) the capital return was less at £107,462.63 (capital of £100,000 plus growth of £7,462.63). But the big difference was that it paid a quarterly yield (income) and this is currently 4.32%, which in 2014 would be about £4,000. Assuming the same each year this would be £32,000 in income. The total return would have been approximately £140,000 including the income.

This includes the three stock market shocks of 2008 / 09, 2011 and 2013.

Obviously this is an example and we would not necessarily recommend one asset for income, nor are future returns guaranteed (and can fall as well as well as rise) but it highlights that cash is not the only option for investing.

Conclusion

What is clear is that investors need to consider cash differently nowadays and accept that things have changed. This may mean considering extra risk, but if an investor is already thinking about longer term investments then that will likely reduce the risk because the asset has more time to smooth returns as funds go through cycles of economic activity.

NOTE: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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