The Risk of Cash
It may be a symptom of “the credit crunch” but we have recently received a number of enquiries from clients about the best way to invest cash. The purpose of these notes is to consider a number of options.
Risk Assessment
Clients will be well aware of the time and effort we put into trying to assess tolerance to taking risk. We use a psychometric questionnaire which provides a “score” and which in turn can be translated into a balance between “defensive” and “growth” assets.
A risk averse client will have a much greater proportion of assets invested defensively than one who could take a more adventurous approach. Cash can be considered as a defensive asset, but even a very adventurous investor is likely to need at least part of his assets in Cash.
The problem with Cash is that it cannot grow in value and so it is at risk of being eroded by inflation. If you put a £50 note in your wallet and leave it there for a week, it will still be a £50 note when you take it out. If you deposit it in a bank account as a saver, the bank will lend it to a borrower. You will earn some interest, but when you take it out again, the capital will still be £50.
If you invest that £50 in an asset-backed investment such as a share or a property then there is the expectation that not only can it provide an income or “yield”, but also that the £50 investment itself may grow. And of course the opposite is true. There may be no yield, and the investment may fall in value.
Financial firms whose job it is to sell investments can show you endless graphs that demonstrate that if you leave an investment for long enough this growth and yield will always return more than Cash and interest – but at the risk that in the short-term you may lose money.
Assuming that you want your capital to grow (and not everyone does), then over the longer term an investment should perform better than a Cash Deposit.
So, what are the options available if you want to hold Cash?
Deposit Account
It is frequently the first choice, but there is a massive difference between the best and the worse. At the time of writing, the best bank deposit will provide 7.01% and the worst is 0.1%. To put that into perspective, if you invested £100,000 your “return” could range from £100 to £7,010.
Even at the top end of the scale, after tax at 40% and inflation (RPI at time of writing is 3.8%), the additional wealth created is a measly £406 or 0.04%! In other words, the interest rate has to be at the very top end in order to just beat tax and inflation.
There are genuinely prudent reasons why you should sometimes hold cash as an asset, but as with any other, it must be managed very carefully.
Individual Savings Account (ISA)
An ISA is of course just a tax-wrapper that can hold either a deposit account (a Cash ISA) or an investment (a Stocks & Shares ISA). It makes sense to use all ISA allowances in order to maximise the tax saving, and for a very cautious investor who is also a 40% tax payer it might actually make sense to invest the full allowance of £7,200 in cash.
Under the new rules which were introduced in April 2008 up to £3,600 may be invested in a cash ISA with the balance (ie up to the limit of £7,200 in total) invested in a Stocks & Shares ISA. Bizarrely, some Stocks & Shares ISAs have the ability to hold Cash, but where they do they have to deduct a standard 20% tax. The interest tends to be not at the highest, but if one only obtained Base Rate (5%) on both the Cash and the Stocks and Shares elements, after 20% tax on part, this would still equate to 7.5% interest for a higher rate tax payer (before charges).
Managed Money Funds
As mentioned above, the rate of return from different deposit accounts can be diverse. Many financial institutions such as insurance companies operate Money or Cash Funds where client money can be pooled together and deposited with banks so as to secure good rates of return.
These can take the form either of deposit accounts or structured as a unit trust. The returns are not usually as good as the best rate available to a private investor who is prepared to shop around and manage his own cash, but they do represent a fair alternative.
By way of example, clients will be aware of the facility to hold Cash on the Mastertrust Account, and over the last 3 months the actual rates of return have been 5.45%, 5.26% and 5.2% respectively.
The tax treatment is broadly similar to money held within a Cash Deposit Account, in that the dividends are treated as interest and taxed at either 20% or 40%.
Capital Gains on Cash?
As explained above, the nature of Cash means that the capital cannot grow. Capital can only be increased through addition of interest.
The Financial Services Industry is nothing if not innovative, and we are aware of at least one financial group that has developed a managed cash fund within the structure of a unit trust – which in turn gives rise to a capital gain.
Again, the rate of return hasn’t been as good as could have been achieved by shopping around for the best rate – but here, through judicious use of CGT allowances it is possible to obtain returns free of tax.
By way of example, taking one such fund which has achieved annualised growth of 4.31%, if that could be taken as a gain within your CGT allowance, it would be equivalent to 7.18% to a higher rate tax payer.
National Savings
By far the biggest attraction of National Savings is their security. That said, the rates of return make them worth considering – especially for higher rate tax payers, where the return is tax-free.
Premium Bonds depend on an element of luck, although if you hold the maximum allowance of £30,000 you would have to be extremely unlucky not to win a prize in most monthly draws. The odds on winning are 22,000:1, and the prize pool represents a return of 3.4%. In combination, what this means is that you should win a prize or two every month. Over the course of a year, these £50 or £100 prizes should add up to around 3.4% – which being tax-free equates to 5.67% for a higher rate tax payer. Of course there is always the chance that one of the prizes could be £1m!
Index Linked Savings Certificates are also worth considering. These currently offer 0.25% or 0.35% above the rate of inflation over 3 or 5 years respectively. Significantly, inflation is defined as RPI, so if this remained at 3.8%, the annual return would be 4.05% over 3 years – or 6.75% to a higher rate tax payer.
Offshore Funds
Clients are sometimes put off by the idea of holding funds outside the UK, for fear that this in some way is unsafe or even illegal. We are not talking about brown paper parcels to the Cayman Islands here!
The UK financial services industry has a substantial and legitimate interest in establishing bases in areas such as Dublin or the Isle of Man where financial regulation is strong.
Holding Cash offshore could be especially useful for UK investors who are planning either to retire abroad, or simply who expect to be paying tax at lower rates at a point in the future. This might be the case for an earner paying higher rate tax who expects to retire paying a lower rate (perhaps through judicious use of personal allowances).
Offshore, it is also possible to enjoy lower tax rates on income brought into the UK or even have interest roll up without any personal tax deduction. The compounding effect of “gross roll-up” means that money works harder and if that can be combined with a lower rate of tax when funds are brought back to the UK then tax savings can be worthwhile.
On the other hand, offshore investments can attract higher charges, and for this reason it’s imperative to shop around.
The purpose of these notes was to suggest that although there may be good and prudent reasons why funds should be held in Cash – there are many ways in which this can be achieved. As Wealth Managers we are in a good position to help clients analyse and select the best type of Cash holding.