Cash Deposits: Be Aware They Are Not Risk Free
A Zurich Club Special Report
By Andrew Vaughn
Risk and return: it is easy to forget sometimes that these two words should lie at the heart of every investment decision. And that should include any decision about whether to hold deposits of cash and, if so, where to hold them.
The decision to hold cash will be driven primarily by our needs or preference for liquidity. Cash has the wonderful advantage that it can be deployed immediately, into anything, and it has a known nominal value. However, when deciding where to place it, investors tend to be lazy and put convenience above a proper assessment of risk and reward.
Last month, we wrote about some potential homes for cash. This month we highlight the potential hazards. Higher rate taxpayers in particular can find themselves earning a rate of interest that is almost negative when tax and inflation have taken their cut. And all depositors can lose the lot if the bank goes out of business. With the current woes facing the global banking sector, that scenario is not impossible to envisage.
So what are the risks of holding cash? They are essentially two-fold; that the cash will lose its purchasing power, and that it may be lost completely by the failure of the financial institution that holds it for us.
Purchasing power is of course a function of price inflation. Over the longer term, it is a key consideration, but in the short term it tends to be overridden by the advantage of liquidity that only cash can provide. Indeed, when non-cash asset prices are falling, the purchasing power of cash is in fact expanding.
Cash Deposits: Interest can be worthless
to higher rate taxpayers
Loss of purchasing power is compensated for by the interest that cash earns. However, investors should be aware that interest income attracts higher rates of tax than dividend income. Indeed, for those with taxable income of between £2,231 and £34,600 after personal allowances, interest income attracts twice the rate of tax as dividend income, as set out in our table. Above that level, investors pay 40% on all interest income.
| UK income tax rates and bands 2007-08 After personal allowances | |||
| Income Band | Earned Income* | Savings Income | |
| Interest | Dividends | ||
| £0-£2,230 | 10% | 10% | 10% |
| £2,231-£34,600 | 22% | 20% | 10% |
| >£34,600 | 40% | 40% | 32.5% |
| *Salaries also suffer National Insurance Contributions | |||
That is enough to reduce a typical deposit account interest rate of 5.5% down to 3.3% — a return which is arguably below the rate of inflation and therefore negative. Certainly, it is a mistake to treat the interest as income and spend it. Bear in mind too, that ‘savings income’ (interest and UK dividends) is treated as the top slice of income, with the starting rate and basic rate bands absorbed first by any ‘earned income’ such as salaries, pensions and rental income.
The message is clear for investors with taxable income that is already above £34,600: it may be costing you money to hold cash deposits. This is the case even if tax is being deducted at source at only 20% or if the deposit account pays interest gross; tax is still payable at 40% and will be recovered by self assessment. Give serious consideration therefore to the tax-free products that are only offered by National Savings and Investments (NS&I). Although their headline interest rates may seem uncompetitive, at the post-tax level the picture is very different. It is currently possible to immediately invest up to £93,000 tax free with NS&I, producing an equivalent gross yield of 6.27% to higher rate taxpayers. It is not even necessary to disclose this income on a tax return.
Now let’s take a look at that second risk we identified — the risk of default by the bank or other financial institution that holds our cash. This is so easily overlooked, but should be at the heart of any cash-holding decision. In days of old, a bank was a place with bars at the window and an impregnable safe. Of course it still is, but the way a bank conducts its business has changed. Rest assured that your cash deposit is not sitting in a vault, or the modern-day electronic equivalent, until the moment you ask for it back. Today, banks are in the business of lending, and they can only pay you a rate of interest if they in turn lend your money out to someone else. Let’s hope that the bank is skilful at deciding who your money goes to. The Bank of International Settlements requires banks to maintain their lending within prudent multiples of their own capital base, and analysts keep tabs on other measures such as a bank’s loan-todeposit ratio. However, lending decisions are made by the banks alone and, as current problems in the banking sector remind us, bad decisions can be made.
So what happens to our cash deposits if a bank goes bust? In the UK, The Insolvency Act, Companies Act and other instruments set out the procedure for sharing out what assets may remain. There is a pecking order, which in broad brush terms places secured creditors first, followed by unsecured creditors and finally shareholders. Little wonder therefore that Northern Rock’s shares had lost 95% of their peak value at one stage last month. At the back of the queue in the event of the company being liquidated, there would be no assets left for shareholders. Secured creditors stand to do rather better. Typically these are bond holders, who have provided funding secured on assets of the bank, such as its properties and working capital. The terms of the bond give them a charge over these assets and the proceeds of their sale. Depositors, sadly, are unsecured creditors and despite ranking ahead of shareholders, realistically they stand to get nothing in the event of a liquidation. Before you lend your cash deposit to a bank, make sure you know where you stand in the queue!
Cash Deposits: Depositors’ Compensation
Scheme — the cupboard is bare
Insolvency law in effect provides cash depositors with no protection whatsoever. However, in the UK the Financial Services Compensation Scheme (FSCS) now protects deposits to 100% of the first £35,000 of each depositors claim. That has increased from a maximum of £31,700 on 1 October of this year. And there is talk of raising the level to £100,000. The Independent points out that the FSCS currently only has access to resources of £139m and that any payouts would therefore require massive additional levies from all the banks. To put that £139m into context, Northern Rock held deposits of £22m immediately before its funding crisis. The bottom line is that UK deposit protection is far from copperbottomed. It is also crucial to understand that building society Permanent Interest Bearing Shares (PIBS) and bonds — popular because of their high rates of interest — are not deposits and would not be covered by the FSCS. Similarly, many so-called investment ‘bonds’ are not secured investments, and their holders would not rank as secured creditors in the event of a liquidation, or be eligible for an FSCS payout.
Cash Deposits: Only National Savings
has no risk of default
For depositors wanting to completely eliminate any risk of default, there is only one option in the UK — National Savings & Investments (NS&I), which is backed by HM Treasury and therefore offers 100% security. Gone are the days of having to fill out forms and queue at the Post Office to access your money.
NS&I now has a website (www.nsandi.com) and will even take deposits over the telephone using a debit card. It offers high levels of interest and instant access. Its Income Bond product, for example, pays 5.59% AER on deposits of over £25,000 with a minimum deposit of £500, a maximum of £1m, and no notice requirement for withdrawal. We reiterate that it is quite simply the only home for cash in the UK that is free from risk of default.
Whether you would get your cash back in real, purchasing power adjusted terms though, is another matter. In fairness, NS&I does offer some index-linked products. However, by both borrowing on a massive scale and controlling the bank note printing presses, governments are hardly incentivised to control inflation. Nor are governments able to control exchange rates, and hence the purchasing power of their currency on the international stage. This is a lesson that US citizens are learning as the dollar has lost around 9% of its trade-weighted value against other currencies in just the last four months.
| National Savings & Investments | |||||
| Product | Maximum Investment | Interest Rate | Interest Rate Equivalent to Higher Rater |
Income on Maximum Investment | |
| Tax Free Products | Taxpayer | £ | |||
| Direct ISA or Cash Mini ISA | £3,000 | per annum | 6.30% | 10.50% | 189 |
| Premium Bonds | £30,000 | in total | 4.00% | 6.67% | 1200 |
| 3-yr Index Linked Savings Certificates (15th issue) |
£15,000 | per issue | IL+1.35% | IL+2.25% | 578 |
| 5-yr Index Linked Savings Certificates (42nd issue) |
£15,000 | per issue | IL+1.35% | IL+2.25% | 578 |
| 2-yr Fixed Interest Savings Certificates (39th issue) |
£15,000 | per issue | 3.20% | 5.53% | 480 |
| 5-yr Fixed Interest Savings Certificates (88th issue) |
£15,000 | per issue | 3.15% | 5.25% | 473 |
| Total Tax Free | £93,000 | £3,497 | |||
| Higher rate tax free equivalent yield | 6.27% | ||||
| Taxable Products | |||||
| Income Bonds | £1 million | 5.59% | 5.59% | ||
| Assumes premium bonds prizes in line with 4% average payout, and IL rate of 2.5% | |||||
Andrew Vaughn for The Zurich Club
First published on December 15th 2007
Get the day’s big financial news in one easy hit! Fleet Street Daily gives you the financial stories that matter. If you’re an investor, you’ll know the importance of staying on top of the news. Every day brings new events, and those events are what move the markets. With Fleet Street Daily you’re one step ahead of the crowd. Because we don’t just tell you what’s happened – we tell you what it means and what you should do about it. Fleet Street Daily is a lively, relevant and entertaining resource designed to help you make smarter investment decisions. Best of all, it’s 100% FREE! So sign up today!