Are you keeping too much in cash?

30th November 2020

Savers holding onto extra cash during the COVID-19 pandemic Some savers are putting their hard-earned money at risk by holding too much on deposit. Savers holding onto extra cash during the coronavirus (COVID-19) pandemic need to consider their long-term investment options, as new data shows the savings ratio for some people has increased during the pandemic.

Figures published by the Office for National Statistics (ONS) show that the savings ratio as a total, which measures the amount of surplus cash households have, has increased during this period. As a result, some households have been able to increase their cash deposits during the pandemic due to a combination of lower discretionary spending during lockdown and households consciously putting more into cash reserves.

Exposed to the risk of inflation
But cash is the investment type most exposed to the risk of inflation. Over the longer term it tends to underperform ‘real assets’ like stocks and shares. Inflation is a very powerful destructive force and understanding inflation is an important factor when it comes to financial success. Over time, inflation can reduce the value of your savings, because prices typically go up in the future.

According to the ONS, in Quarter 2 (Apr to June) household spending (adjusted for inflation) growth was negative 23.6% compared with Quarter 1 (Jan to Mar)[1]. The largest negative contribution to growth was from restaurants and hotels, which fell by negative 89.4% compared with Quarter 1.

Households holding onto more cash
The largest positive contribution to growth was from food and non-alcoholic beverages, which increased by positive 3.5% compared with Quarter 1. These ONS figures are also consistent with the Bank of England’s estimates that the deposits in household bank accounts grew £17bn a month from March to June, more than triple the rate seen in the previous six months.

But as some households are able to hold onto more cash, many have received underwhelming rates of return on their cash savings. National Savings & Investments (NS&I) recently reduced rates on its savings products, while other cash accounts offer relatively modest returns.

Emergency cash
A cash savings buffer is key as it provides protection in the event of a loss of income. This means you have something to break your fall and avoid short-term borrowing to cover day-to-day costs. It is normally recommended that households keep enough cash on hand to cover between 3 to 6 months of essential spending. This money should be held in an easily accessible account, although this typically means accepting little or no interest.

Cash savings
Once you have enough to cover a financial emergency, it is important to start to make some of that money work harder. Locking money up in a deposit account can help savers to achieve a modest return, although rates on cash remain very low.

Stocks & shares
Over longer periods of time, historically the stock market has performed well. There have been and will continue to be plenty of bumps and bruises along the way, but the overall trend has been upwards
Investing can deliver better long-term returns, but markets go up and down over time and past performance is not guaranteed, so it is important when investing to leave the money untouched for several years. One of the most efficient ways to invest is through a Stocks & Shares Individual Savings Account (ISA). This offers tax-efficient growth and every adult can invest up to £20,000 during every tax year, which runs from 6 April to 5 April the following year.

If you have built up a lump sum, this could be invested into an ISA account in one go; however, depending on your particular situation, it may be appropriate to gradually invest in funds or stocks over a period of several months. This process, known as ‘pound cost averaging’, helps to ensure you smooth your investments and don’t invest all your savings at a peak in the market.

Lifetime ISA (LISA)
Another form of ISA account, the LISA, offers a savings boost from the Government. This is only allocated to those who use the money to purchase a first home or do not access it until they turn age 60. So it is predominantly aimed at first-time buyers, or people who have maximised their pension contribution allowance. If you withdraw it for any other reason, then a penalty applies.

Pensions
Saving into a pension fund attracts pension tax relief, rewarding savers with a 20% or 40% top-up for basic and higher-rate taxpayers respectively. Strict penalties apply on withdrawals before age 55, but for those who want to commit money towards their future this is a very tax-efficient way to invest for the long term.

Those people in employment who are eligible to be auto-enrolled into a pension should already have regular contributions to their retirement fund being made through their salary. If they have extra disposable income they may want to consider paying more into their pension.

Some workplace schemes may not be able to facilitate this, in which case a personal pension provider can receive contributions. Normally 20% tax relief will be applied and higher-rate taxpayers may need to recover additional tax relief via their tax return.

Source data:
[1] https://www.ons.gov.uk/economy/nationalaccounts/satelliteaccounts/datasets