Is it time to call an end to cash ISAs?

Cash ISAs were, for a long time, seen as an easy way to put aside moneyandearn a return from a generous interest rate. However, over the last ten years we have seen interest rates drop significantly, to the current record low of 0.1% and the Bank of England has made clear it is not ruling out the prospect of negative interest rates – meaning you could have less money just by keeping it in the bank.

When you combine this with the spectre of a perennially devalued pound pre and post Brexit, the idea of holding money in a cash ISA seems a lot less attractive than it used to. As you can see from the pie chart below, more money is now invested in stocks and shares ISAs than in cash ISAs.

Data taken from HMRC ISA statistics 2018-19
https://assets.publishing.service.gov.uk/government/uploads/system/ uploads/attachment_data/file/894771/ISA_Statistics_Release_June_2020.pdf

A quick look across cash ISAs offering the ‘best’ returns doesn’t look promising. The best instant access cash ISA, according to consumer champion Which?, only offers a rate of 0.9%AER.

An instant-access cash ISA allows you to withdraw money whenever you like. There are other cash ISAs that offer better rates of interest, but they lock you in for longer; typically several years. If you want to make a withdrawal you will usually have to pay a penalty fee. Looking at these ISAs the best available rate is 1.25% for a fixed cash ISA with a five-year lock-in.

This rate is much better than the current rate of interest from the Bank of England (0.1%), but it is not going to protect you from the effects of inflation, which stood at 1.8% at the beginning of 2020 (although it has subsequently dropped during Covid). And there are other big variables in this landscape to consider.

Following the financial crash 12 years ago, the world’s central banks took on a programme of massive, unprecedented, quantitative easing (QE). This was essentially governments taking on more debt in order to print more money which would act as stimulus for the global economy. The effects of the multiple QE programmes are still debated by economists, but there is a consensus that the result was to allow inflation to continue to rise, albeit around a modest 2%, while keeping interests rates very low – typically below 1% but also straying into negative rates.

For the average person, without high levels of wealth, assets and investments, this meant that their cash was always going to be losing purchasing power because any interest earned was being far outstripped by inflation – the below chart shows inflation (CPI) rising above the value of cash over the last ten years. These concerns continue to be valid today as more financial stimulus is lined up by central banks to tackle the recession we’ve seen during the global pandemic.

Source: MacroBond/Nutmeg

This shows that while cash will always have the advantage of being fully liquid (spendable), when it comes to investing for the future, the low yields offered by cash ISAs suggest holding cash in a cash ISA over the long-term will lead to your pot losing value.

For UK citizens there is another issue to think about here. Following the Brexit vote in July 2016 the pound lost around 15% of its value in just a few hours. Over the last four years it has struggled to make back this loss and continues to suffer from low valuations and outlooks against the US dollar and the euro as the uncertainties of Brexit and the UK’s deal with the EU roll on.

Source: MacroBond/Nutmeg

Therefore, holding cash in a currency that is losing out to inflation while depreciating against other currencies has an inherent risk. Locking your pounds into a fixed-rate cash ISA could leave you very exposed over time as these factors eat away at your cash’s value. It is, of course, possible to invest in other currencies but there are transaction costs and the FX rates are constantly moving – convertibility has a price.

So, if cash ISAs are losing their appeal over longer timeframes, say three or more years, what are the alternatives for those wanting to find a relatively low risk investment option for their money? Many investors are now able to take advantage of the digital innovation in the finance space to select managed portfolios that are easy to access, completely transparent and which allow them to choose their own level of risk.

Nutmeg offers investment ISAs with a very low barrier to entry – you can invest from as little as £500 and each year your first £20,000 invested in an ISA is tax-free. While the risk landscape is different to investing in cash (investing inevitably brings with it some risk of loss), even by selecting the lower risk setting for your portfolio – typically investing in bonds and some cash – past performance indicates you would see considerably bigger returns than any current cash ISA is offering. The below chart shows Nutmeg’s fully managed, relatively low-risk (level 4) portfolio returns and our discretionary, high risk portfolio (8 and 10) returns against a 1.25% cash ISA over the last five years.

Source: MacroBond/Nutmeg

The below chart shows what those returns look like once we have adjusted for inflation.

Source: MacroBond/Nutmeg

So, while cash ISAs may not be the best guard for your wealth, there are other investment options to help you keep ahead of inflation without taking on uncomfortable levels of risk.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance. A stocks and shares ISA may not be right for everyone and tax rules may change in the future. If you are unsure if an ISA is the right choice for you, please seek financial advice.