Figures released by the British Bankers’ Association (BBA) today show a jump in savings in July as new rules on tax-free accounts came into force.
Net deposits to NISA (New Individual Savings Accounts, the successor of ISAs) in July totalled £4.9 billion, a dramatic increase from the £18 million placed into the accounts in July 2013. Savers usually shift funds into the accounts at the start of the new tax year in April, as seen on the chart below. This year, however, the lure of a higher allowance has encouraged them to wait until the summer.
Monthly changes in ISA/NISA deposits, £ millions
Under the new rules announced by the Chancellor in his April budget, the amount individuals can save in cash without paying tax on the interest earned has nearly tripled. Last year, each person was able to save up to £5,670 in a cash ISA and the same amount in a stocks and shares ISA. The limit on the proportion of cash in ISAs has now been completely lifted, giving people the choice of how to split their money between cash and riskier stocks and shares, while the total ISA limit has also been raised to £15,000.
The rush to take advantage of the increased saving allowance in July suggests that the policy is having the desired effect. In some respects, this is good news: the UK household savings rate is low, and the Office for Budget Responsibility expects it to fall further in the coming years. Given the importance of savings in helping households protect themselves against poverty in old age and unexpected events like redundancy, policies which encourage saving should be applauded.
However, there are reasons to worry that the new ISA policy is actually discouraging some positive savings behaviour. The vast majority of ISA savers choose cash accounts: the most recent data, for 2012/13, shows these account for 80% of all ISAs. There is no reason to think that the mix between cash and stocks and shares has changed with the increase in the total allowance; indeed, the fact that people have waited until July to make their deposits suggests they are taking advantage of the new higher cash allowance. But with the Bank of England base rate stuck at 0.5%, the average rate of interest earned on these cash accounts is just 0.86%. This might be tax-free, but it is still a pretty pitiful return on capital. By contrast, those with money invested in stocks and shares ISAs were able to achieve an average return of 9.4% in 2013/14.
Returns aren’t the only reason for holding savings, and there are good arguments for holding a certain amount of savings in cash to access in case of a rainy day – one rule of thumb may be to hold between three and six months’ salary in a fairly liquid form in case of redundancy or ill health. At the UK average salary of £26,500, however, this equates to less than £10,000 (after tax and national insurance). Above this level, savings could be put to better use, both from the perspective of the individual and the broader economy.
Investing in stocks and shares does require you to take some risk – the capital invested may not be returned, and earnings are not guaranteed as with fixed interest rate offers on cash savings accounts. However for those able to take full advantage of the new £15,000 NISA allowance, taking a low-risk approach and investing solely in cash is unlikely to be an optimal investment strategy. Most of these individuals, having already put cash aside for a rainy day, would benefit from diversifying, investing the remainder of their allowance in stocks and shares and earning a higher return. Additionally, while money held in cash ISAs will in many cases be used to finance mortgage lending, money invested in stocks and shares is directly channelled to productive use in firms, providing a boost to the rest of the economy.
Even when interest rates, and thus the returns on cash, rise, there are good reasons for those with significant savings to diversify their portfolios. But evidence shows that people tend to minimise financial losses when choosing how to save and invest, rather than maximising financial returns. The current policy, rather than encouraging diversification, could promote a reliance on cash, reinforcing behaviour driven by innate loss aversion and a lack of financial literacy.
A reinstatement of the lower limit on cash NISA saving could encourage people to invest in stocks and shares to use up the total allowance. This would provide a way into a wider range of savings and investments products for a broad section of the population, using the well-recognised ISA brand to introduce people to different types of saving and increasing the effectiveness of the nation’s investments. While other policy suggestions to encourage better savings behaviour would require large-scale programmes of financial education, limiting the cash component of tax-free savings schemes is a relatively simple way to nudge people towards more diverse investment portfolios.
Even with a change to promote investment in stocks and shares NISAs, just increasing tax-free savings allowances is sufficient to boost saving across the population. We do not yet know anything about the people who increased their saving in July in response to the changes in NISA regulation. However it’s highly likely that they are exactly the same people who benefitted from the old ISAs. Notably, despite consistent increases in the ISA allowance since 2008/09, the total number of ISA accounts has fallen. The increase in the tax-free savings allowance benefits only those who are already able and willing to save £15,000 a year, and does nothing to help those on lower incomes to save. If the government is serious about encouraging savings, a new approach is needed.