How much should you keep in cash?
Is cash still king? The twin pressures of inflation and low interest rates are making cash savings less attractive – but what are the alternatives, and do they suit your needs? Our guest article from Armstrong Watson Financial Planning reconsiders the case for cash.
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The main attraction of cash is that... it’s cash. The money is there exactly when and where you need it, and typically you know exactly how much you have. Providing a combination of financial stability and capital security, it’s a tempting way in which to accumulate wealth. Cash is great to have to hand in an emergency – both individuals and businesses should have ready access to cash reserves for emergencies. It’s also simple: bank accounts and cash ISAs are widely available and easily understandable.
But of course, there’s a downside: recent returns on cash have been dire. As convenient and stable as it may be, those who wish to see their money grow in real terms are likely to need a move away from cash at some point. Returns from savings are eroded by inflation, while cash-based interest rates continuing to remain at historically low levels with little prospect of improvement in the short term.
Cash versus inflation
Recently inflation has jumped above 2 per cent, surprising many and exceeding the Bank of England’s target. Economists also expect it to rise further. Meanwhile, cash interest rates are lagging far behind. This means that the longer cash is held, the less it is worth in real terms – so the return it produces is actually negative over the longer term (for more on this, see our article here).
This predicament is driving many to non-cash investments such as equities and bonds. However, the challenge here is to find the right balance between cash (which still has many advantages) and non-cash.
HMRC figures show that since ISAs were introduced back in 1999, the amount saved into the cash version has grown compared to the stocks and shares equivalent. More than 10 million cash ISAs have been subscribed to in each of the last ten years. In the 2015/16 tax year, around £80 billion was invested into ISAs, with almost £60 billion of that invested into cash. Additionally, the annual ISA contribution limit has continued to rise, and from 6 April 2017 a maximum of £20,000 can now be invested. There is also no longer a requirement that a separate cash limit be held.
When comparing the interest rates available for cash ISAs to some bank accounts it can often be tempting to take up a bank’s non-ISA cash rate, as some banks have begun to offer higher rates of interest. Theoretically, you can hold as much as you like in cash, but should the institution fail the maximum compensation you can claim is £85,000 under the Financial Services Compensation Scheme.
The arrival of tax-free savings interest
What’s more, the savings landscape has changed. The interest on deposit savings is now paid without any tax deducted at source, thanks to the introduction of the Personal Savings Allowance (PSA) in April 2016. This means basic rate taxpayers can earn up to £1,000 of interest tax-free, and higher-rate taxpayer can earn £500 (additional rate taxpayers do not receive the PSA). The PSA is in addition to your annual ISA subscription, and any prizes from National Savings & Investment (NS&I) Premium Bonds which are also tax free.
But what you should be aware of is the effect this tax-free income may have on your tax band. For tax purposes, all savings interest is included with all other sources of income you receive. This means that, when added to your other income, it could technically push you into a higher income tax band, thus increasing your tax bill even though the interest paid to you was tax free. You should therefore take particular care if your income is close to a tax band threshold.
The recent Budget confirmed NS&I’s new market leading savings bond from April 2017, but with a maximum savings level of just £3,000 and its 2.2 per cent interest still sitting below inflation, this won’t do much more than slow the erosion of some people’s savings.
Is it time to take on more risk?
Cash saving has definitely seen better days. Nevertheless, cash does retain some advantages. People with short-terms savings goals (e.g. homebuyers) need the ready accessibility of cash, while those with little appetite for risk may prefer even a slow decline in the value of their savings to the risk of sudden drops.
But those who seek an actual return on their savings will now be looking to investments instead – especially if short-term access is not required. This approach inevitably exposes capital to higher risks and so requires more regular monitoring, but when handled properly it has the potential to beat the effects of inflation in a way that cash (at present) seems unable to do.
A financial adviser can help you determine the level of risk you can afford to take in order to achieve your goals, over the relevant timeframe. There are many possible solutions to the balancing act of risks vs returns, so you need to seek independent advice that takes full account of your personal circumstances, objectives and needs – as well as your income tax position. Cash may no longer be king, but that doesn’t mean your long-term saving plans have to abdicate.
Armstrong Watson Financial Planning has operated for over 30 years in the North of England and South Scotland. It is recognised by the Chartered Insurance Institute as a Chartered firm of financial planners. Find your nearest office:
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