Cash – the Magic formula – Part II: The Options

Originally published January 31st 2023

In Cash Part I – The Magic Formula – we looked at how much cash you should hold by introducing three simple, tried, and tested rules designed to help protect you in an emergency, to ensure you can meet short term commitments and for those who are withdrawing from their investments, protect you from extreme market volatility.

Now, in Part II we will consider what options are available for savers for keeping their money on deposit, which is fast becoming a hot topic with interest rates expected to continue rising well into the first quarter of 2023 as an anti-inflationary measure following nine consecutive rate rises by the Bank of England.

The top three questions I am currently being asked by clients are:

• Where can I get the best rate for my cash?

• How safe is my cash?

• Should I tie my money up to get a better interest rate?

So, let’s explore each question in turn…

Where can I get the best rate for my cash?

Firstly, the days of your investment platform provider, such as, abrdn or Transact, offering a return on your cash are largely gone and money market funds should not be thought of as cash as they contain instruments which change in value daily.  For this reason, where we do recommend a cash allocation it is usually for the payment of charges or to fund a withdrawal or income payment only.

Cash savings are therefore better held off-platform and for most people their needs are likely to be met via their primary banking provider, ensuring that their short-term cash needs can be readily accessible.

For larger amounts of money, you might be surprised to know that we would typically turn to the same comparison websites as you might use and lean towards accessibility and security.

How safe is my cash?

It is true to say that banks are much better capitalised today than they were in 2008, regulation around things such as capital adequacy are much tighter and the culture of risk taking has largely been reined in.  

Today, we know that our cash is protected up to £85,000 by the Financial Services Compensation Scheme (FSCS) and £170,000 for a joint account.  It is however important to remember that these limits apply per institution not per account and with so many connected financial institutions it is important to check the position with your provider.

It can be impractical for many to hold multiple accounts across many financial institutions just to benefit from the FCSC protection and so we often steer clients towards the Direct Saver provided by National Savings & Investments. Backed by HM Treasury who guarantee up to £2m per person, this instant access account currently pays 2.6% at the time of writing.

The bigger risk in our view is the corrosive effect of inflation on your savings over time and therefore the importance of only holding in cash just the right amount to meet your needs, see Part I HERE.  This is best illustrated by the chart below which plots our 60:40 equity-bond portfolio against cash and inflation since the portfolio was launched thirteen years ago – essentially £100,000 held in cash would today need to be worth £139,320 to have held its purchasing power against inflation, whereas is fact it would be worth £106,758.  That is an effective loss of £32,562 – or £2,500 p.a. 

For reference had your £100,000 been invested in a’ 60:40 portfolio it would be worth £213,628 today which just goes to underline the importance of only holding what you need in cash and investing the rest.

Should I tie my money up to get a better interest rate?

A quick look on a well-known comparison website shows that today it is possible to lock in an interest rate of between 3.2% to 4.3% over terms of 6 months to 5 years.  Bank of England base rate today is 3.5% and inflation is 10.5% for reference.

The key here is to understand that whatever the rate is on offer, the provider thinks future rates will be higher or rather they believe they can obtain a higher return on your money themselves than they are willing to pay you.  Recently, an economist at AJ Bell explained how the market now expects interest rates will peak at 4.5% during 2023.  If that is true, savers would be locking into a rate 0.2% to 1.3% below base rate, may be unable to exit the term early or suffer penalties in doing so.

At Capital, as mentioned earlier we tend to prioritise accessibility and security over interest rates on cash savings, keeping cash at a level only what you need, accepting it won’t return more than inflation and let this fact be offset by returns in your investment portfolio.

Charles’ Top-Tip

The ability to hold cash in an ISA is a legacy from the days of TESSA’s prior to their merger with PEPs to eventually become what we know today as ISAs.  A much better option in my view is to hold cash outside of an ISA and, where possible in the name of a non or lower rate tax payer.

This frees up the ISA allowance (currently £20,000 per person per tax year) to hold your investment portfolio shielding it from Capital Gains Tax and Income Tax.  Imagine, holding all that lovely 60/40 growth shown earlier in a tax-free wrapper?