Ahead of the Spring statement, there were mounting concerns the Chancellor was on the precipice of making drastic changes to Britain’s savings market. Although nothing specific was announced, HM Treasury confirmed that ‘the government is looking at options for reforms to Individual Savings Accounts’ (ISAs). There is a chorus of voices, from policy wonks on the centre-left, to investment firms in the City, calling for the chancellor to shake-up ISAs.
Successive governments have viewed tax-exempt savings and investment accounts as a way to get more people saving and investing. ISAs were introduced in 1999 by Chancellor Gordon Brown, replacing Tax-Exempt Special Savings Accounts and Personal Equity Plans. Simply, they are tax wrappers applicable to cash savings and a range of investments. Each adult is allocated a £20,000 annual allowance, and returns are exempt from taxation. The two most popular ISA variants are Cash, and Stocks and Shares.
Policy wonks on the left regard the ISA scheme as an overwhelmingly costly tax break for the well-off which needs trimming. Currently, the tax relief scheme means almost £7bn a year stays with taxpayers that would otherwise go to the Treasury. Since the annual allowance stands at almost two-thirds of average annual income, it is little surprise only 7% of ISA holders max out the annual allowance, with the overwhelming majority making smaller deposits. And, by grace of the Personal Savings Allowance, providing a segment of interest income free for basic and higher rate taxpayers, one needs a savings pot above the national average at competitive rates to really need a cash ISA. The same cannot be said for the Stocks and Shares variant, however, as the now much-reduced Capital Gains Allowance could be easily exceeded by the proceeds of selling modest investments made five years ago.
Whilst higher-income households do make better use of the scheme, that is not good enough justification to hobble it. There are several tax relief schemes which are utilised far more acutely by the wealthy – like the Enterprise Investment Scheme – but they are in operation precisely because they encourage behaviour that is broadly deemed to be very desirable. ISAs are no different, functioning as an established part of Britain’s savings and investment ecosystem. Critics also miss that ISA allowances have been victim to fiscal drag, just like other elements of the tax system. If the annual allowance had kept up with inflation, it would stand £5,000 higher today.
Beyond the fixation on distributional fairness, the government is doing the right thing taking seriously the nation’s savings problem. Britons save less of their income than their counterparts in other developed countries, resulting in households poorly resilient to financial shocks. It also means a growing number of people will need state support in retirement. Around a quarter of under 35s lack any pension savings at all. Our national bias for present consumption is stifling the investment we need for tomorrow.
The government is also right to recognise far too many Britons cling to cash, to their own detriment over the long-term. Amongst G7 countries, we have the lowest ownership of stocks and mutual funds. About a fifth of adults have invested in the stock market before, versus six in ten in the US – a country also with a household savings ratio low by international comparison. During the 2010s, cash savings returned less than a percentage point per annum, whilst UK equities returned around eight. So even in today’s higher interest rate environment, equities are, and almost always will be, a better long-term investment vehicle.
Against this backdrop, ministers – under heavy lobbying from investment firms – are considering capping the annual contribution limit to £4,000 for Cash ISAs in an attempt to strong-arm savers into investing. Financial advisers think this would work, and it is understandable why. Nearly £400bn is languishing in current and savings accounts earning little-to-no interest, and the prospect of savers paying more tax on their earnings might jolt them into exploring other products. As it stands, almost a fifth of people have never heard of a Stocks and Shares ISA, despite it being better suited for building wealth over the long-term than its Cash sibling. Advocates of this reform argue savers would be better off, and the government’s growth mission would be aided by the billions of pounds suddenly flowing into UK equities. What’s not to like?
The problem is this: if you keep most of your long-term savings in a cash ISA, despite the availability of alternative products offering higher returns, then you are likely not very responsive to financial incentives, at least in the context of savings and investment decisions. If this is the case, why would a change in tax incentives – which are also financial incentives – elicit a change in your behaviour? If allowances are altered, it seems probable that a lot of these people will simply stay put in cash, and accept the additional tax burden. Instead of promoting investing, the government would merely be penalising cautious Brits – including those wisely holding cash for short-term goals, like a housing deposit – by taking a slice of their already meagre returns.
Changes to tax incentives can only do so much when financial literacy is poor, with less than a fifth of people reporting a good understanding of savings products, and even less understanding investments. It is foreseeable that many Brits, risk-averse, would continue to hold money in accounts bearing meagre rates of interest, rather than adopt a product they do not understand, and likely view as dangerous, given stark warnings about the risk of investment losses are mandatory upon firms.
Even if the policy change did produce the desired shift in behaviour, the result may be deeply negative for building societies, which play a significant role in the mortgage market. Unlike the big banks who can turn to wholesale markets, building societies are required by law to raise 50% of funding from customer deposits. Reduced flows to Cash ISAs would impact their ability to offer competitive rates to aspiring homeowners. Considering the government is keen to boost the size of the mutual economy, not to mention home ownership, this policy change could prove counterproductive.
It is also important to consider the segment of the population with the most to lose from this change – the elderly. People in retirement cannot often afford to plough money into equities, since their time horizons are smaller. A sudden drop in the value of investments in retirement can be the difference between affording essentials or facing hardship; passing on a bequest or nothing at all. Elderly savers are losing out as much as their younger counterparts by holding so much of their money in low interest accounts, but this is where the FCA should, and already has begun, stepping in.
The solution to our national savings problem is not strong-arming savers into specific products, but empowering individuals with the knowledge and freedom to build financial security on their own terms. Rather than revising down cash ISA allowances, the government should focus on meaningful ways to improve understanding of savings and investments, particularly amongst lower-income groups. This starts in formal education, but a straightforward reform could also be encouraging savings providers to list the current inflation rate and assumed real rate of return alongside their savings interest rates. Relaxing rules around providing financial advice might also lead to better informed retail investors. Instead, what the government is currently mooting leans too closely toward compulsion. And confidence, not compulsion, is what long-term wealth creation depends on.
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