The Motley Fool

Why I think a cash ISA could be your biggest retirement savings mistake

As ever, greater rewards from an investment are only possible when risks also rise. As such, many individuals may be dissuaded from buying a range of FTSE 100 and FTSE 250 shares as a result of the potential for the loss of capital.

In contrast, the risk of loss from a cash ISA appears to be zero – provided an individual’s investment doesn’t exceed the level of protection provided by the regulator. Therefore, a cash ISA may appear to be a worthwhile means of planning for retirement, since it offers a return of around 1.5% with limited risk.

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Inflation

The problem, though, is that over the long run the returns on a cash ISA are likely to be beaten by inflation. This could mean that there’s a risk an individual’s spending power is eroded throughout their lifetime. This could leave them with insufficient capital from which to draw an income in older age, since £1 in 20 years will not be able to buy the same value of goods or services at it does today.

Therefore, with inflation currently above the best rates available on a cash ISA, there’s a risk investors will ultimately fail to achieve their goal of having a sizeable nest egg in place by retirement.

Monetary policy

Of course, interest rates are currently close to historic lows. Over the long run, it could be argued that these are likely to rise, and cash ISAs will gradually offer higher returns with limited risk.

However, the rate of inflation is likely to have a significant impact on the level of interest rates. In other words, significant increases in rates are unlikely to take place unless there’s evidence the economy is overheating. Therefore, inflation is likely to be continually one step ahead of the rates that are available on a cash ISA. This means that the real return of a cash ISA may continue to be negative, even if the UK’s monetary policy tightens over the long run.

Risk/reward

For individuals who are retired or close to retirement, lower-risk investments could prove to be a sound idea. However, for investors who have a long-term time period, buying riskier assets which offer higher potential returns could prove to be a good move. The FTSE 100 and FTSE 250 could experience major bear markets over the coming years. But over the long run, their track records show they’re likely to deliver a recovery. In fact, they’ve always recovered from bear markets, and have gone on to post higher highs.

Therefore, utilising a stocks and shares ISA for the bulk of a retirement portfolio could help to build a significant nest egg in older age. It could be used to generate a second income which is far higher than that of a cash ISA in real terms.

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