By: BILL BLEVINS
Financial Correspondent, Blevins Franks
What do you get when you cross a bank account with stock market returns? Interest rates. One minute they’re going up, the next there’s the possibility of a cut.
Over recent months we’ve seen how uncertain interest rates can be. One thing we can be certain about, though, is that we won’t be seeing the double digit rates we had in the 70s and 80s any time soon, if ever again.
The current interest rates offered on bank and building society deposit accounts are higher than we’ve had for some years, but even then, once you deduct your tax rate as well as your inflation rate, the net interest rates offered actually aren’t very attractive to many account holders. The EU Savings Tax Directive is another reason why offshore bank accounts have lost some of their previous appeal.
The savings interest rate offered by banks and building societies will always be restricted. The Bank of England and European Central Bank each sets its base rate – the rate at which they lend to other financial institutions and which is determined by economic conditions.
High rates are usually set as a defence against rising inflation. Once inflation is under control, rates usually fall to encourage business expansion and consumer spending.
Retail banks are free to set their own rates but they follow the lead set by the Central Bank. If the Bank of England base rate is 5.75 per cent, savings accounts will typically offer rates ranging from around 3.5 per cent to 6.5 per cent, depending on the type of account and how much money you have in it. By the time you deduct your tax and inflation rates there’s not much left.
To give yourself the possibility to earn greater rates of return, your returns can instead be linked to stock market.
When you deposit your savings in a bank account, you are making a choice to accept restricted returns and possibly very low ones in return for keeping your capital secure.
When you invest in the stockmarket, you are making a choice to risk your capital in return for the possibility of high returns.
It is not easy to choose between the two options because there are strong pros and cons on both sides. However, you don’t actually need to choose between these two options – there are other choices you can make, ones where the pros may outweigh the cons.
First of all, your savings should not be invested in either the stock market or cash. Rather, in many cases, you will have both of these in your portfolio, along with other investments to balance out the two extremes, like bond and property funds.
Secondly, even the stock market part of your portfolio could be structured to a lower level of risk than you’d expect, with the right diversification tools in place.
Another interesting option is to have an account which takes a completely different approach from traditional bank accounts – interest will be based on stock market performance and not the Central Bank base rate. In other words, your original capital will be as safe as it is in a bank account, but returns will not be calculated using the base rate. Instead there is a potential for greater returns, depending on how the markets perform over the term of the investment.
With such an account, usually called a “guaranteed investment account” or “guaranteed investment bond”, no interest is paid to you over the investment term. Instead, the interest payment is calculated based on how well certain stock markets have performed over the length of the term and added to your account at the end.
Since the interest you earn is based on stockmarket performance, it can be higher. Some accounts offer unlimited growth potential and there is an account available which will add an extra bonus interest payment (over 30 per cent) if none of the stock market indices concerned end the term at a lower level than they started.
Provided you leave your capital in the account full term, there is no risk of a capital loss. Even if the markets fall over the term, you will still receive your entire capital back, just as you would do with a regular bank account.
However, there is no such thing as a ‘no risk’ investment, and in this case the risk is that if all the stock markets concerned have fallen below their starting values at the end of the term, you will only receive back your original investment. While your capital is guaranteed, the interest isn’t.
One important issue to consider when opting for such an account is that the investment term is for around five to six years. While you are free to withdraw money at any time, you would lose the capital guarantee. You need to be reasonably confident that you can tie up your capital for the entire term.
A guaranteed account would not normally be suitable for all your savings. You need to have enough capital accessible for your needs over the years, whether in the bank or in equity or bond investments. But by investing part of your savings in a guaranteed account you will be protecting this part and lowering the overall risk profile of your portfolio.
A final benefit these accounts offer over regular bank accounts is that they protect your interest from tax. The interest you earn is exempt from the EU Savings Tax Directive and no local income taxes will be payable on it unless you withdraw money from it.