Cash ISAs continue to be relatively popular. They were originally designed to encourage saving through avoiding the tax levied on interest earned from cash savings (which no longer applies to the first £1,000 in interest received each year). And while they have been successful at helping people to put aside a cash sum, the reality is that they offer miserable returns in the long run.
With inflation rising and interest rates set to remain low over the next couple of years, investing in the FTSE 100 could be a smarter move when it comes to planning for retirement. It could help you to generate a sizeable net egg, while a cash ISA may be worth far less in real terms further down the line than the money originally invested in it.
Low returns
Inflation hit a six-month high in August, reaching 2.7%. While its sudden rise caught many people by surprise, it has been above the Bank of England’s 2% target for a prolonged period of time. With interest rates having been at historic lows for around a decade, this has meant that many investors’ cash ISA balances will have fallen in real terms in recent years.
Looking ahead, this situation is likely to remain in play over the medium term. UK interest rates are expected to be little more than 2% in 2020, which is due to be less than inflation over the same period. Therefore, every £1 in a cash ISA today is likely to be worth less in future than it is at present. And with Brexit uncertainty being high, it would be unsurprising for interest rates to stay low and for inflation to spike as uncertainty surrounding the process builds.
High returns
The FTSE 100, in contrast, offers an inflation-beating return outlook. It has a dividend yield of 4% at the present time, which means that even if the index does not rise in value, it is still likely to provide a positive return after inflation. This should mean that every £1 invested in the index grows over the long term, with additional capital growth also likely. In fact, in the last 20 years the FTSE 100 has delivered an annual return of around 3%, which suggests that a high-single-digit annual total return is achievable in the long run.
Risk
Clearly, investing in the FTSE 100 could lead to capital losses. The index may face a bear market in future years, and this could easily wipe out any gains made from its 4% yield. The reality, though, is that the index has always recovered from challenging periods.
While in the short run it could disappoint and cause investors to record paper losses, in the long run it is likely to significantly outperform a cash ISA. Since retirement planning is generally a long-term activity, the FTSE 100 appears to have a much more favourable risk/reward ratio compared to a cash ISA. As such, now could be the right time to focus on the index when it comes to building a retirement nest egg.
