Generally speaking, cash ISAs are a great product. Cash ISAs allow you to save money without interest received being liable for tax. This is especially attractive for higher-rate taxpayers who have to pay out on savings interest over £500 a year. And if you’re an additional rate (45%) taxpayer, using a tax efficient wrapper like a cash ISA is essential because there’s no savings allowance at all for taxpayers who fall into this bracket.
However, despite the tax benefits of cash ISAs, they have one fundamental flaw. If you’re using a cash ISA today, rather than growing your wealth, your money is losing value.
According to analysis by Moneyfacts, 2017 was the worst year on record for cash ISA returns. The average instant access account offered just 0.93% interest on balances.
The problem is that this stingy level of interest isn’t enough to protect your portfolio from the scourge of inflation. Last year, the Consumer Price Index — the most widely used measure of inflation in the UK — averaged 2.6%, so the average cash ISA saver saw the value of savings eroded by 1.67% in real terms for the full year.
The long-term figures are even more depressing. According to my calculations, over the past 10 years to keep pace with inflation, your savings would have had to have been growing at a rate of 2.9% per annum. As the average Bank of England base rate between 2008 and 2017 was only 0.5%, savers have been left short-changed.
If cash ISAs are such a bad investment then, where should you be looking to get the best return on your money?
Well, one solution is to use low-cost funds to invest in the stock market. Over the past 10 years, the FTSE 100 — the UK’s leading stock index — has produced an average return around 8% per annum for investors, easily outperforming inflation and more.
However, if you’re not comfortable investing in shares and would rather put your money to work in a way that comes with less risk, but still manages to nullify the negative impact of inflation, a good option is to use a low-cost bond fund.
Bonds have similar qualities to cash. They generally come with significantly less risk than investing in equities, primarily because the price of bonds doesn’t vary significantly day to day. What’s more, bonds come with a guaranteed level of income which, unlike equity dividends, cannot be cut whenever the company feels like it.
Bond funds provide diversification across many different bond instruments at a low cost so all you need to do is sit back and relax.
The returns for each bond fund vary, depending on the level of risk involved. High-grade corporate bond funds can add 5% per annum, while government bond funds yield less (although still more than the average cash ISA interest rate) but are considered to be more secure.
So, if you want to protect and grow the value of your money over the long-term, it makes sense to ditch your cash ISA today. As my figures above show, the stock market is a much better option. And if you don’t want to invest in shares, bonds are the next best thing.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.