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Why a Stocks and Shares ISA, and not a Cash ISA, could help you beat the State Pension

Saving for retirement through a Cash ISA may not be the most effective means of beating the State Pension. Certainly, living within your means and building up a retirement nest egg is a great idea. But accepting the low returns of a Cash ISA while the stock market offers a better chance of long-term capital returns could be an ineffective use of your capital.

As such, now may be the right time to switch your focus from a Cash ISA to a Stocks and Shares ISA. Through diversification, you could limit its risks and generate higher returns which reduce your dependency on the State Pension in older age.

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Capital growth potential

A Stocks and Shares ISA offers a greater opportunity to generate capital growth than a Cash ISA. Over the past decade, for example, the FTSE 250 has recorded an annualised growth rate of around 9%. When its dividends are added to that figure, it’s a total return in excess of 12% per year.

Over the same time period, a Cash ISA is likely to have posted annual returns that are less than 2%. At present, for example, it’s difficult to obtain a rate of more than 1.25% on a Cash ISA.

In terms of planning for retirement, the difference between the returns available from a Stocks and Shares ISA and a Cash ISA could be significant. Over time, the impact of compounding is likely to widen them yet further. For example, over a 10-year time period, a £1,000 investment in the FTSE 250 — which delivers an annual growth rate of 9% — would be worth £2,367. The same investment in a Cash ISA yielding 1.25% would be worth just £1,132.

Possible challenges

Of course, many savers are dissuaded from opening a Stocks and Shares ISA because of perceived higher costs, complexity and risks. In terms of costs, the rise of online sharedealing means that annual management fees are minimal, while the cost of buying shares can be as low as £1.50 in a regular investment service.

Buying shares is riskier than holding cash in terms of there being a potential for losses. But through diversification, you can reduce overall risk. Furthermore, the stock market has always recovered from its downturns to post new record highs. As such, adopting a long-term strategy can lead to high returns – even if there are challenges along the way.

Moreover, with a Cash ISA offering such low returns, it may fail to match inflation over the long run. This could reduce your spending power and mean you remain dependent on the State Pension in older age. This could be viewed as a significant risk – especially with the State Pension age set to rise and its payment unlikely to provide financial freedom for most people in older age.

As such, now may be the right time to focus your capital on a Stocks and Shares ISA rather than a Cash ISA.

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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.