Cash ISA returns are set to plummet

Almost 15 million UK savers will see a dramatic decline of about £250 million a year in the interest they earn on their cash ISAs over the next twelve months - but you can avoid the loss if you act now.

According to research by the Halifax, UK savers hold over £130 billion in cash ISAs. On average, the 15 million ISA accountholders subscribed £2,426 each in the last full financial year. But since most cash ISAs pay variable rates of interest, these savers face a big drop in the interest they can expect to earn over the next year.

The Bank of England cut base rate on October 8th from 5% to 4.5% and economists are now predicting that by next summer base rate will be at 3% or less. Meanwhile, the results of the government’s bank rescue package are starting to work through the money markets, and an inevitable consequence - indeed one on which the success of the plan depends - will be a reduction in the interbank rates at which banks lend to each other. It is because interbank rates are high that banks have bid up the rates for High Street deposits to their current levels, which are well above the Bank of England base rate. As interbank rates come down, banks will not need to pay such high rates, so if base rate is 3% next year you can expect High Street savings rates to be 4% at the very most.

A 2% cut in the average interest earned on cash ISAs adds up to a massive £250 million collective loss for ISA investors. So how can you avoid it?

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Strategy 1: Secure a fixed rate
The simplest strategy is to switch to a fixed rate ISA. Your ISA provider may have a fixed as well as a variable rate account on offer, in which case it should be easy to switch from one to the other. Take Nationwide, whose variable rate cash ISA currently pays 4.8% on balances up to £10,000. Nationwide also offers a Fixed Rate ISA Bond paying 5.75%, and you can opt for a term of one, two or three years.

If you don’t need access to your cash, go for a longer period fixed rate account. If, as economists predict, the recession lasts until 2010, interest rates are likely to stay low until 2011. On a £10,000 ISA, earning an extra 2% over three years will clock up an extra £600 in tax-free interest.

If your provider doesn’t offer a fixed rate option or only a very poor rate, then consider switching to a different one. Here are some other top rates for fixed rate ISAs:

- Bradford & Bingley, Fixed Rate ISA, 1 year, 6.25%, Min £3,600
- Northern Rock, Fixed Rate ISA, 3 or 5 years, 6%, Min £500
- Halifax, Fixed Rate ISA Saver, 2, 3 or 4 years, 5.45%, Min £500
- Birmingham Midshires, Postal Fixed Rate ISA, 1 year, 6.15%, Min £1
- Nationwide, Fixed Rate ISA Bond, 1, 2 or 3 years, 5.75%, Min £1

1. See all our best buy ISAs

Strategy 2: Switch to an income fund
A change in the ISA rules included in the last Budget allows you to switch your ISA from cash into investing in funds. There are many funds that invest in fixed income bonds issued by governments and companies. Recent market turbulence has meant you now get higher interest rates from these funds, but managers insist that with funds investing in what are called ‘investment grade bonds’ issued by big companies, there’s little risk of a default but you get interest at up to 7%.

Three such funds with good records are Invesco Perpetual Corporate Bond (yield 7.03%), Blackrock High Income Bond (yield 7.05%) and Newton Strategic Corporate Bond (7.5%).

The best way to buy them is by setting up an ISA with a fund supermarket Hargreaves Lansdown. All these funds levy an initial charge of 3% to 5% but within the HL Vantage self-select ISA, you pay no initial charge on a purchase.

These funds are designed for people who want to hold for the longer term and use the income to pay their bills. And be warned: capital values can and do fluctuate.

See our best buy self-select ISAs

Strategy 3: switch to a growth fund

Most of the time, investors in shares get far less income than they’d get from cash on deposit in the bank. But there aren’t normal times and there are several ‘equity income’ funds you can buy in a self-select ISA that will pay out dividends of 5-6% over the next year.

There’s less security with share dividends because companies can and do cut them. Just look at the banks, which account for over a fifth of all UK dividends but which, under the terms of the government rescue package, won’t be paying any cash dividends to shareholders for the next year at least. But set against that is the fact that over a 5-year period, you can expect dividends to increase. In the long term, they usually rise at a rate greater than inflation.

On top of that, investors generally compare the dividend yield on shares with returns from cash and from safe government bonds. If cash rates fall to 3% next year and you can get only a fixed 4.5% from rock-solid government bonds, then getting dividend yields of 5% from shares will start to look extremely attractive.

Many funds continue to quote historic figures, which are based on the dividends they got from their bank shares over the last year. Five high-income funds investing in shares are:

All these funds hold at least 10% of their investment in bank shares, and that means the actual income received over the next year will be lower than these figures suggest. Managers are reluctant to tell me how much lower but will soon be forced to come clean. My guess is that the actual yield in the case of each of these funds is 1.5% - 2% lower than the historic yield shown above.

Still, collecting dividends starting at 5% a year and likely to rise fairly steadily over the long term could be an attractive option if you can lock away your money for a term of 5 years or more.

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Important risk warning - please read

The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.