Derek Gawne outlines how ISA investors can plan ahead to maximise their returns without taking too much risk

In terms of financial planning, ISAs (in addition to their forerunners, PEPs and TESSAs) have long played a key role due to their tax advantages. The key benefits are that no additional UK income tax is due on the underlying investments and there is no liability to capital gains tax when investments are subsequently disposed of.

Since the ISA rules were changed in April 2008, there are now two types of ISA: cash ISAs and stocks and shares ISAs. As part of these changes, ISAs were extended indefinitely, and the outlook for them to continue looks positive, although the current regulations could be amended by the current or any new government.

However, the success of ISAs to date would seem to make changes unlikely and they should therefore continue to play a significant part in integrated financial planning for the foreseeable future.

Here to stay
John Brasington, the chairman of the Tax Incentivised Savings Association (TISA), confirms this view: ‘ISAs should form the basis for every individual’s savings and investment strategy. For those with modest savings, a cash ISA will protect their interest from tax. For the medium- to high-net-worth investor, ISAs should be a core part of their portfolio. Within a stocks and shares ISA, the investor may switch investment without incurring capital gains tax.’

There is one potential drawback – cash held within a stocks and shares ISA will attract a deduction of 20 per cent, but incomegenerating investments incur no tax on their income. Furthermore, the ISA is a very flexible plan, which is why it has proven to be so successful with investors.

There are many situations where this ‘plan for all seasons’ can be applied, reviewed below in terms of the most obvious timescales for savings – short, and medium to long term.

Short-term investment
The investor with a time horizon of one to two years for their capital is unlikely to want to take on any form of risk and would be looking for a relatively safe home for their investment.

This is often seen as an emergency fund or the savings for large outlays such as holidays and major household purchases that have been specifically identified. The most obvious short-term option is the cash ISA.

The cash ISA accounts for approximately two-thirds of overall ISA money invested, and approximately 94 per cent of this is held in standard deposit-type accounts with banks and building societies.

The key benefit of the cash ISA is that interest is paid gross with no income tax liability. For this reason, investors who want to retain part of their savings in cash should look to utilise the cash ISA allowance (currently £3,600 per annum), since not only is the interest paid gross but these accounts have historically provided the highest rates of interest.

The benefits of gross interest are an even greater incentive for higher rate taxpayers. An annual rate of interest of 5.4 per cent for example, which, until recently was an achievable rate, equates to an equivalent gross rate of nine per cent for a higher rate taxpayer.

However, interest rates have fallen dramatically over the past year due to the effects of the economic downturn and the credit crunch. The falls are significant and are currently dramatically affecting returns for the cash ISA investor. The Bank of England’s Monetary Policy Committee cut the base rate to just 1.5 per cent in January, and then to one per cent in February, the lowest in the Bank’s 315-year history.

Commentators are forecasting that rates could go lower still, as the government and the Bank seek to calm investment markets and restore the UK economy to a growth footing. Indeed, in the US rates have already been cut to between zero and 0.25 per cent.

Alternatives to cash
As a result of the scale of the change, and the difficulties being faced by those who rely on interest from their cash savings, there has been a move to a ‘chase-the-rate’ mentality, where funds invested in cash ISAs are regularly moved from provider to provider.

The average return on cash ISAs has fallen to an average of around three per cent, and that is not taking into account likely adjustments for the recent rate cuts. As the deposit returns fall lower and lower, investors are considering alternatives.

One unexpected problem for cash investors resulted in a BBC news headline ‘“Cash” funds are not always cash!’ Standard Life had a fund (its Pension Sterling Fund) that many retired investors, or those close to retirement, had been attracted to for its excellent returns and the ‘relative safety’ of cash.

In mid January this fund was devalued overnight by some five per cent. It transpires that the fund had only invested a small proportion in cash deposits, while the rest was placed in ‘other’money market instruments that were not as safe. It even had exposure to mortgage-backed securities – those of the credit crunch variety.

It is, therefore, vitality important when shopping around for this type of investment that you read the small print and consider how much additional risk will be acceptable. In the case of the Standard Life fund, there is currently a debate as to whether their small print was clear and not misleading; no doubt time and the regulators will decide.

One example of a ‘near cash’type of fund is the Fidelity Moneybuilder Cash ISA. Its fact sheet states,‘The fund aims to provide an attractive level of income, with a high degree of security through investments in cash deposits and “near cash” instruments. These include bank deposits, short-dated gilts and local authority bonds, all of which provide a high level of security. The manager’s policy is to invest primarily in cash deposits.’

The fund currently has almost 90 per cent cash on deposit; in other words, it does what it says on the tin.The strategy that the wise deposit investor should adopt is to read the small print and get precisely what they want.

The medium to long term There is a great and continuing debate as to what is the correct time horizon for mediumto long-term aims and objectives. Broken down simply, it is generally agreed that, if the expectation is that savings are being built up or capital invested for longer than two years, then you need to look for growth greater than inflation.

The knock-on consequence of tumbling interest rates is that the returns from cash ISAs are set to follow, if not immediately then certainly as fixed-rate offers come to an end. This creates a clear dilemma for investors who prefer cash as a safe home for new investments but are interested in how to maximise their return from existing deposits.

The problem besetting them is one of risk in the current environment and, looking forward, they must be aware that low risk very much means low return.

How much risk to take?
The events of 2008, and their resulting impact on investment markets, have been dramatic, with financial news making frontpage headlines throughout the year. The term ‘credit crunch’ has entered everyday language, with attention focusing on the shock waves that have pulsed through the world’s financial system.

Meanwhile, the real economy is in recession, providing a further knock to investor sentiment. All of this will clearly fill cautious investors with trepidation about moving away from cash, which, by and large, stood them in good stead throughout 2008. But with investment markets having fallen so far, the question we need to ask is how much of the bad news has already been factored into the prices of equity and fixedincome (i.e. corporate bond) investments?

Increased flexibility could hold the answer. From April 2008, it has been possible to transfer from a cash ISA to a stocks and shares ISA. This may well be worth considering while, of course, being mindful of the additional risks involved.

Helping companies borrow
Corporate bonds could be a first step. Companies, like individuals, frequently need to borrow money to help finance their operations, and this they do by issuing corporate bonds, on which they pay a fixed rate of interest to investors for a predetermined period, before repaying the loan on the due date.

The risk to investors is that the company defaults and is unable to make the interest payments or repay the loan. The greater the risk that a company will default on its bonds the higher the rate of interest it will be required to pay to attract investors.

Broadly speaking, corporate bonds can be split into two categories: lower-risk or ‘investment-grade’ bonds; and higher-risk ‘high-yield’ bonds. So care is needed to check how any potential fund is invested.

Jeremy Tigue, F&C Management’s head of global equities, explains that ‘To illustrate the enhanced returns potentially available from corporate bonds, you need to look at the difference in the returns offered by the instantaccess accounts from major banks and building societies compared with the rates of interest available on the same institutions’ senior corporate bonds, their most secure bonds’.

Locking in potential
The other attraction of corporate bond funds currently is that, following the sharp falls in bond values that took place in 2008, due to heightened concerns that defaults would increase, there is potential for capital appreciation as well as an enhanced income.

To some extent, of course, this depends on the economic situation turning out to be better than investors currently believe, but investment markets have a habit of overshooting both on the way up and on the way down, driven by investor sentiment, though this is by no means guaranteed. The next step up the risk ladder would be to venture into stocks and shares.

The situation is eloquently summed up, from an income perspective, by Ian Lance, fund manager of the Schroder Income fund: ‘Over the past year, confidence in equities has taken a considerable hit. There is a risk that investors will look to cut their equity exposure even further. However, we believe this could be precisely the wrong thing to do, especially as far as income stocks are concerned.We are convinced that equities, and income stocks in particular, now look very attractive against a backdrop of falling interest rates.’

BlackRock Asset Management also believes that there are opportunities from the growth sector for equities: ‘We believe strongly that we are well into what is known as a “global super cycle”, the current example being the “commodity super cycle”, which is driven by the growth coming particularly from China and India. This, in itself, might not cause the growth we predict but, when added to the increasing scarcity of many of the world’s natural resources, growth in the value of these resources cannot, long term, be avoided.’

A question of balance
Chris Evans, fund manager of the Charles Stanley Regular High Income fund, believes that there is a middle way between corporate bonds and equity funds: ‘Our fund has a mandate to invest in corporate bonds and equities and, although at present we have a negligible presence of the latter, we now predict that, as the corporate bond star wanes, the investment climate for higher-yielding equities will be more favourable, and we will be able to move accordingly with a proportion of the fund with our normal cautious approach’.

There are further alternatives for investors who remain concerned about taking on additional risk. By dripping investments into a chosen market over a period of time, via a regular savings scheme, the investor can seek to smooth out the peaks and troughs of the market. This is known as pound cost averaging.

As with all investment strategies, there is no one correct answer, so the motto for ISA investors is to identify your time horizon, calculate the risk you are willing to take and maintain a healthy and balanced mix to your investments. And above all, read the small print.