3.1.5 Savings products – rock-bottom rates and government incentives
Here you start to explore the different savings choices for a household that has surplus income or has budgeted to create surplus income. You begin to learn to make some important distinctions between savings products:
- products that earn interest where the nominal value of the capital (the amount you put into the product) stays the same
- investment products, which you look at later, that can make capital gains and capital losses, where the investment you make can subsequently go up and down in value.
There are thousands of different savings products available, and such choice can be daunting. Yet it’s possible to make sense of the choice with reference to available interest rates and, where applicable, the taxation of that interest. An understanding of these, as well as a clear idea about the reason for wanting to save, should provide enough background information to make a more informed decision about a product.
The financial services industry is required to show interest rates on all savings products so that they can be easily compared. For savings products, this rate is called the Annual Equivalent Rate (AER).
The AER allows a comparison of savings products with different interest payment patterns. The AER is the annual interest rate that savers receive, taking into account when interest is actually paid (for instance, annually, quarterly or monthly).
The concept of real interest rates is important when looking at investment returns. These show the return after the impact of price inflation has been taken into account. Thinking in real terms can help to show what’s happening to the value of savings over time. For example, the significance of a 5 per cent interest rate on savings is dependent on the rate of inflation, and is very different at either 1 per cent or 6 per cent.
In the latter case, the real interest rate is actually negative, that is, your savings could buy less in a year’s time, even after the receipt of interest. Theoretically, this could cause some people to decide to consume more now and save less. Conversely, when inflation has been high in the UK, it can make people want to save more to make sure the real value of their savings is not reduced.
In the UK, only National Savings & Investments periodically offers an inflation-proofed savings product in the form of index-linked certificates. For example, holders of the 48th issue five-year certificates are guaranteed to get their original investment (their ‘capital’) back at the end of five years with interest equal to inflation over the period plus 0.5 per cent a year, in other words a real return of 0.5 per cent. Someone who invested £1000 in these five-year index-linked certificates on the first date of their issue in May 2011 would, on their maturity in May 2016, have found that they had a valuation of £1174.24, giving a return since the start of the investment of 3.3 per cent a year once inflation had been added to the real return.
At times of low inflation, the return on index-linked investments can seem unattractive, but they come into their own in periods when inflation is expected to be high. Most savings products do not offer inflation-proofed returns.
On 29 September 2015, the Bank of England published news that came as no surprise to the UK’s beleaguered savers. Rates on savings accounts were at a historic low. At 1.43 per cent, the interest on cash ISA accounts was the lowest since records began in 2011. It was no better for notice accounts, where the average rate for these products was the lowest since records began in 1999.
The reasons for this are well known. Bank Rate has been at a historic low since March 2009. With economic conditions weakening globally in recent months, in the wake of problems in China, no early increase to this key rate is expected. The Bank of England’s Funding for Lending Scheme (FLS) continues to give financial institutions access to cheap money for lending to businesses, thus reducing their need to attract funds from personal investors.
Better news for savers comes with the tax breaks available to them. Investors can place savings in cash Individual Savings Account (ISA) products – up to an annual limit set by the government – with the interest earned being free of income taxation. In 2018/19 the limit for such investments is £20,000 per person. In the March 2016 budget statement it was announced that a new ‘lifetime ISA’ would be available from April 2017 for those aged under 40 years. These new ISAs will allow tax-free savings of up to £4,000 per annum with the government topping up balances by £1 for every £4 saved. Lifetime ISAs, which can be built up until the age of 50 years, are intended to help people save for property purchase or to help provide income in retirement.
In addition, and with effect from 2016/17, the first £1000 of interest earned from non-ISA savings accounts is also free from income tax for basic-rate taxpayers. For higher-rate taxpayers, the first £500 of interest is tax-free. Also for low earners, with an aggregate of income and interest earnings of up to £16,000, no income tax is payable on the first £5000 of interest.
A new savings scheme for those on low incomes was also unveiled in March 2016 with those on in-work benefits who save £50 per month for up to 4 years getting a 50% top up from the government (up to a maximum of £1200).