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State Pension: I’d dump a Cash ISA and Premium Bonds to buy FTSE 100 dividend shares

Deciding where to invest for retirement can be a tough choice. On the one hand, products such as a Cash ISA and Premium Bonds have appeal since they offer a potential return without risk. But on the other hand, they may ultimately lead to reduced spending power since their returns are less than inflation.

As such, FTSE 100 dividend shares could offer a more appealing risk/reward ratio. Certainly, there’s scope for capital loss, but for individuals who have a long-term time horizon, they may provide a better opportunity to overcome the disappointing State Pension.

Return potential

With the State Pension amounting to just £8,767 per year and the age at which it starts being paid set to increase to 68 over the coming decades, having a passive income in retirement is becoming a necessity for many people.

The FTSE 100’s dividend yield of 4.6% means it may not take an impossibly large amount of capital to generate a sizeable passive income. For example, a £190,000 nest egg would more than double the State Pension if it’s invested in FTSE 100 shares and their dividends are used as an income.

By contrast, a Cash ISA’s 1.5% interest rate and the Premium Bond’s annual prize rate of 1.4% would require a significantly larger nest egg to double the State Pension. In fact, it would require a nest egg of £585,000 for a Cash ISA, while the £50,000 limit on investments in Premium Bonds would generate a return of only £700 per year, on average.

As such, investing in the FTSE 100 could produce a higher income than a Cash ISA or Premium Bonds in retirement. It may also be a better means of building a nest egg as a result of its higher income prospects, as well as its growth potential.

Risk of loss

As mentioned, Cash ISAs and Premium Bonds may be appealing to investors who don’t wish to risk losing money. However, when inflation is factored in, both products may lose money for investors. In other words, the value of £1,000 invested in a Cash ISA or Premium Bonds is expected to decline in terms of the goods and services it can buy in 10 years versus today.

By contrast, £1,000 invested in the FTSE 100 today could be worth significantly more in 10 years even after inflation is factored in. Certainly, there’s scope for capital loss during that time. But by diversifying across a number of companies and holding through more challenging periods, it may be possible to build a larger nest egg.

For retirees, even if a company’s shares fall in value, the receipt of dividends may mean a portfolio of FTSE 100 stocks still offers the opportunity to become less reliant on the State Pension in older age. As such, now could be a good opportunity to buy a range of large-cap income shares.

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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.