It Matters Where You Put Your Money

The 2025 autumn Budget threw up a few interesting debates - and one of the most polarising aspects of the budget was the changes to the Cash ISA.

In order to 'encourage younger people to invest' the Cash ISA will revert back to a more familiar format, with the amount able to be contributed into a Cash ISA reduced to £12k, but with Stocks & Shares ISAs continuing to have a £20k maximum contribution limit.

This means that you can put £20k a year into a Stocks & Shares ISA, £12k into a Cash ISA and £8k into a Stocks & Shares ISA - but not £20k into a Cash ISA. That is unless you are over 65, in which case you get a special carve out.

This has triggered a lot of conversion - firstly around the special carve out for the over 65s, but also for the removal of an extra £8k contribution to a Cash ISA - and it is this second area which we will focus on today.

And what is interesting about much of the critique of the policy change is the number of people looking to use Cash ISAs as their main long-term investment vehicle.

This one is certainly an interesting one, because I'm not really sure that the Cash ISA is the one you should be focusing on whether saving in your youth, or in retirement.

The Merits of a Cash ISA

Let me start by saying that a Cash ISA does have merit - mostly because the cash you pay on cash interest, particularly as a higher rate tax payer, is pretty brutal. 

If you have £100k in savings and you are earning 4% in cash interest, then whilst the bank will pay you a nice healthy £4k per annum, as a high rate taxpayer the government will come along and claim £1,600 of that interest, leaving you with a net £2,400 in interest.

Or at least they do until April 2026 when they will increase their claim to £1,768 of that interest, leaving you with a net £2,320. 

Considering that you started with interest of £4,000, that is not a great result - and it reduces the net return to a measly 2.32%, despite the fact that interest rates of 4% would give you a sufficient return on your capital.

The key benefit of a Cash ISA is that it protects you from this taxation - and if you have spent the past few decades building up your Cash ISA, this can save you a lot of tax across a lot of capital.

From a tax perspective this is a very good thing for you as the owner of a Cash ISA.

Cash ISA vs Stocks & Shares ISA

What it really comes down to though isn't whether you are better off having cash inside or outside of an ISA - inside is clearly better - what matters is whether you use a Stocks & Shares ISA or a Cash ISA.

In a Stocks & Shares ISA you will avoid tax on dividends or income from bonds - whilst also avoiding any capital gains tax - and so this vehicle also has important tax reducing benefits.

The Problem with Cash ISAs

The problem with Cash ISAs in my mind, is that at most you can fix them for five years - and during this period of time you will get less interest than you would get if you invested in government bonds. You also miss out on some of the benefits that you get from a bond (i.e. it may go up in value).

Right now you could take out a Cash ISA for five years that would earn you 4% per annum, but you could equally buy Government Bonds for thirty years that would earn you 5% per annum.

And whilst the best Cash ISAs pay out around 4% for a five year term right now, through 2011 to 2020 the rates of interest were pretty dire, paying out at best around 2%. And this lost decade was costly to cash savers - but potentially very lucrative for holders of long-term Government Bonds.

Cash vs Bonds A Fairly Brief History

Interest rates have generally been heading down since the late 80s - when rates peaked at 15% - but let's jump forward to the early 2000s, and compare the performance of 5 year fixed interest and a 30 year bond.

Back then long-term government bonds and cash both paid similar yields of around 5%. And for our example we will assume that we split £100k equally between a Cash ISA and a 50 year Government Bond in 2005. In 2025 we will then review performance over the last twenty years.

Over the first 5 years both pay out 5% interest - and in 2010 it is time to take out a new Cash ISA. Unfortunately by this point rates have dropped, and so a new Cash ISA is taken out at 2%, whilst the Government Bond not only continues to pay out 5%, but has also risen in value to £69k.

You see the price of bonds will change day to day based upon the interest rate. And in general, if the interest rate at the time has gone down, the value of the bond will go up - and if the interest rate at the time has gone up, the value of the bond will go down.

The reason for this is that if you could get 5% on a Government Bond, but only 2% in Savings interest then everyone (in theory) would flock to the Government Bond as it would be paying much higher interest. 

The increased demand for the Government Bond reduces the price until the lower rate no longer attracts the same demand - the equalisation point isn't necessarily at the same rate of interest, as UK savers are far more comfortable holding a saving account than a Government Bond.

By 2015 the interest rate is down further to 1.1% when we buy our next set of Cash ISAs, whilst the Government Bond is still paying out 5% and now worth £103k.

After another five years the interest rate has once again fallen to 0.5%, whilst the Government Bond is still paying out 5% and now worth £130k.

But rolling on to 2025, the interest rate has risen to 4% and whilst the Government Bond is still paying out 5%, it's value has fallen away to about £60k.

What is important about the Cash ISA is that at no point does the value of the capital change from our invested sum of £50k - and whilst in this scenario this was a bad thing, in a scenario of climbing interest rates this would be a good thing.

The Problem With Bonds

That scenario of increasing interest rates was feasible - maybe they climbed up to 15%, and then we would have made more money from our savings.

But the key is not to throw away all our cash savings and go all in on Government Bonds - the key is to realise that different assets have different characteristics with different risks and opportunities. And indeed in my view, going all in on ones asset class always carries a level of risk to it.

Instead, my belief is that the true value lies in a more diversified position.

You can see from this chart that movements in the value of the Government Bonds have been large over the last 20 years - and if you need access to money for near-term expenses that can be a real issue (even if interest rates rise temporarily):

But over this period of time we could have held Government Bonds throughout and kept up a 5% cash yield, irrespective of the wider drop in interest rates.

A Mixed Portfolio - Bonds and Savings

So let us consider what would happen in a portfolio that combined both savings and long-term Government Bonds.

By having £50k in Government Bonds and £50k in savings we would be in a position where higher rates would see us outperform on the Cash ISAs, and where lower rates would see us outperform on the Government Bonds.

And in reality the optimal thing for us to do is probably to increase the proportion in long-term Government Bonds when rates are high (heading towards 10-15%), and then to decrease the proportion in these long-term bonds when rates are low (heading towards 0-2%).

In our example, we could at the 5 year point have sold 20% of our Government Bonds - and benefited from the 100% increase in their capital value. Then after 10 years we could have sold a further 20%, and then done the same again after 15 years.

After the values dropped away after 20 years, we could have then repurchased Government Bonds and been able to continue to earn 5%, but on a far higher sum of capital.

To explain this, we can run through how this would look in reality...

• Year 0 - £50k in Government Bonds paying £2.5k
• Year 5 - £82.4k in Government Bonds paying £2.0k (20% sold), and £20.6k in Cash paying 1.1%
• Year 10 - £83.2k in Government Bonds paying £1.5k (40% sold), and £41.4k in Cash paying 0.5%
• Year 15 - £38.4k in Government Bonds paying £1.5k (40% sold), plus £41.4k in Government Bonds paying £2.07k (repurchasing using the increased cash position)

Through this strategy we turn our original capital of £50k into a final capital position of £79.8k - merely by recognising that rates of sub 1% are unlikely to last forever.

If interest rates had instead risen over the same period, then we could have looked to do the opposite thing and bought more long-term Government Bonds as the value of the ones we already held fell. We could then re-balance towards a 50:50 split if interest rates came down again.

We can run through this as a scenario assuming interest rates climbing up to 8%, 10% and then back to 5% in year 15 :

• Year 0 - £50k in Government Bonds paying £2.5k
• Year 5 - £31.3k in Government Bonds paying £2.5k, plus £10k in Government Bonds paying £800 (total cost £60k)
• Year 10 - £25.0k in Government Bonds paying £2.5k, plus £8k in Government Bonds paying £800, £10k in Government Bonds paying £1k (total cost £70k)
• Year 15 - £50k in Government Bonds paying £2.5k, plus £16k in Government Bonds paying £800, plus £20k in Government Bonds paying £1k (total cost £70k)

Note that the figures in this example are hypothetical and fairly approximate (unlike the prior scenario that was using real data).

By the end the total value of the Government Bonds is worth £86k having been bought for £70k - and again we are working on the basis that interest rates will vary in that range from 0% up to 15%, but will probably not sit at the extremes indefinitely.

In this sense I would summarise by saying that Cash ISAs reduce liquidity and capital risk to near-zero, but in return carry a high risk in terms of guaranteed future income.

By contrast, Government bonds carry high liquidity and capital risk (as the value can be down when you try to sell), but near-zero income risk (assuming the government doesn't default).

Stocks and Shares

Well what about stocks and shares? If combining savings and bonds can balance out bother our liquidity and income risk - would adding stock and shares also smooth things out further?

Like bonds the price of stocks and shares will vary throughout the trading day - and so what you bought for £10 per share might become worth £12 per share, or it might become worth £8 per share.

Within the world of stocks and shares there are different companies with different risk profiles, but generally there are two major categories for potential investment.

The steadier investments are typically older companies, and these are likely to pay out dividends at a high percentage of their annual income.

For example an insurance company such as Aviva will operate it's insurance business, and then it will pay out the majority of it's earnings to shareholders via dividends.

Companies paying out a high proportion of income via dividends tend to provide a reliable income stream through this method, but other companies that are more focused on growth and the reinvestment of capital may pay no dividend at all. Other companies will sit in the middle of these two extremes, pursuing a mix between growth and steady operations.

Potential investors are often put off by the pricing risk of stocks and shares, but in the case where you have invested in companies paying out a high proportion of income, the total payout can be fairly reliable.

As an example the UK's FTSE 100 (the most valuable 100 companies on the UK stock exchange) tend to have older and steadier companies than say the S&P 500 in America, and so the dividend pay yield is higher and more stable as an income source.

During the worst of Covid - a once in a generation cash impacting event - the cash income from the FTSE 100 barely pulled back. Instead companies mainly focused on reducing the amount of their own shares they repurchased in the market.

An implication of this fairly steady performance is that the cash yield on the FTSE 100 has been more stable than the long-term cash yield from repurchasing savings at 5 year intervals. 

Once again we must revisit our summary and where Cash ISAs have a liquidity risk that is as good as zero as it can be, there is a high risk on future income stability.

By contrast the FTSE 100 has high liquidity risk (maybe not as high as long-term bonds given how much they can shift with interest rates), but a lower risk on future income stability when compared to cash savings (although not as low as long-term bonds).

This flies in the face of a lot of perceived wisdom, but in many ways this is because much of the perceived wisdom is anecdotal and not evidence based. 

You could have bought into the FTSE 100 earlier in 2025 and bought in at a prevailing dividend yield of 3.4-3.5% (competitive with cash savings income payouts) - although after recent climbs in values the yield has dropped down to 3.1%.

But this excludes any retained income used to deliver future growth and also excludes cash spending to repurchase shares that increases the total yield to 6%.

Those share repurchases can often be ignored in any calculations, but they are a benefit to an investor.

For example if a company has 100 shares and you own 1 share then you own 1% and will get 1% of any dividend payout. However, if the company repurchases 1 share then the total share count reduces to 99 and your holding increases to 1.01%. As a result you get 1.01% of any dividend payout - a higher proportion than without the share repurchase.

Indeed with the FTSE 100 being largely ignored by global investors, much of it's return has been coming from the payout from dividends, rather than for the growth of it's companies in recent years.

Since the companies in the FTSE 100 often pay out a large portion of their income the index itself can be flat for prolonged periods of times (more recently it has been climbing in value) - but the total return including the payment of dividends can see significant growth.

The index itself should still generally be growing over time as not all payments are paid out, but this highlights how you have more stability from income than growth via this index.

The Mixed Portfolio

For stocks and shares the valuations will generally climb during periods of lower interest rates as this creates more favorable business conditions, but the linkage between rates and stocks is far less pronounced than for either savings or bonds.

As a result a stock index that pays out a large share of profit as dividends - like the FTSE 100 - can offer another counter-weight to both savings or long-term bonds.

If you were to split your assets a third between savings, long-term bonds and the FTSE 100, what you would find is that the value of the later two components would be subject to variations which might impact you if you need to access all that cash in the near term.

But in return those two would offer far more stable income over the long-term than savings which could be impacted by prolonged period of reduced interest rates.

Outside of ISAs

Outside of ISAs things get more complicated, because here you have to consider the impact of taxation.

We have already briefly touched on this subject when we noted that outside an ISA our cash savings would earn 4% on paper, but a high rate tax payer will only get to keep 2.4% until April 2026 and then 2.32% after.

There are some allowances and exclusions for this, but for a high rate taxpayer these are fairly small - with the main benefits going to those with combined pension or salary below the personal allowance.

If your combined salary and pension falls below the personal allowance you get an additional £5,000 allowance for savings interest (where there is be no tax paid on that interest). This is on top of a usual £1,000 allowance - which reduces to £500 for higher rate tax payers, and to nothing for additional rate tax payers. The £5,000 allowance tapers down to zero for every penny of income up to £5k above the personal allowance.

These allowances aside - savings are expensive from a tax perspective - and whilst government bonds might pay a higher rate of interest, the same taxes apply.

Investment in a stock index like the FTSE 100 will see dividends tax, but there will be no tax paid on retained earnings or due to stock buybacks. However, when you sell if there is a gain in value between the buy and sell point you will owe capital gains tax on that gain.

For long-term Government Bonds you pay the same rate of tax as that paid on a savings account, but (an uniquely to Government Bonds vs other bonds) you pay no tax on capital gains.

An additional option for cash investment outside of an ISA is via Premium Bonds where the rate of interest is not guaranteed each month, but where interest is not taxed at all. These Premium Bonds can be used to reduce your taxable income and keep you within a certain tax threshold overall, but are capped at a total value of £50k.

For a low rate taxpayer we have the following scenarios :

• FTSE 100 (INCLUDING buybacks) - 6.0% total yield pre-tax, dropping to 5.7% total post-tax (10.75% tax rate on the dividends from April 2026, no tax on the buybacks) - yield historically stable, but not guaranteed, and buybacks likely to be lower in lean years
• Government Bonds - 5.0% yield pre-tax, dropping to 3.9% post-tax (22% tax rate from April 2026) - interest rate guaranteed for 30+ years assuming the government doesn't default
• Premium Bonds - expected 3.6% yield (no tax) - interest varies month to month
• Cash - 4.0% yield pre-tax, dropping to 3.1% post tax (22% tax rate from April 2026) - interest rate guaranteed for 5 years, may increase or decrease after that
• FTSE 100 (EXCLUDING buybacks) - 3.1% yield pre-tax, dropping to 2.8% post-tax (10.75% tax rate from April 2026) - yield historically stable, but not guaranteed

Here the FTSE 100 delivers the lowest cash yield post tax, but has uplift from additional share buybacks, and potential growth in the index (the higher the buybacks the higher the likely future growth in the index). It is worth noting that at the point of sale capital gains must be paid on any growth in value in the index - and it is more tax efficient here to hold indefinitely.

For a high rate taxpayer these change to :

• FTSE 100 (including buybacks) - 6.0% total yield pre-tax, dropping to 4.9% total post-tax (35.75% tax rate on the dividends from April 2026, no tax on the buybacks) - yield historically stable, but not guaranteed, and buybacks likely to be lower in lean years
• Premium Bonds - expected 3.6% yield (no tax) - interest varies month to month
• Government Bonds - 5.0% yield pre-tax, dropping to 2.9% post-tax (42% tax rate from April 2026) - interest rate guaranteed for 30+ years assuming the government doesn't default
• Cash - 4.0% yield pre-tax, dropping to 2.3% post tax (42% tax rate from April 2026) - interest rate guaranteed for 5 years, may increase or decrease after that
• FTSE 100 (excluding buybacks) - 3.1% yield pre-tax, dropping to 2.0% post-tax (35.75% tax rate from April 2026) - yield historically stable, but not guaranteed

An additional complexity to these calculations is that you pay tax on salary or pension first, then on interest from bonds or savings, then on dividends and then on capital gains. Note that here any interest from untaxed sources like ISAs and Premium Bonds do not affect the tax on taxed income.

The impact of this is that dividends are the most likely income source to be pushed into higher rate taxation - and so a large block of income from cash savings can push up the tax rate on your dividend income.

My Personal Take

For me personally, I am a fan of the FTSE 100 as a source of reliable income. You have a set of fairly diversified stocks where the cash yield is likely to be fairly stable - and so on that basis I would view a bank savings account and the FTSE 100 as being equally an option in terms of an income generating asset.

In terms of reliability this income does not compare with a 30 year Government Bond, which assuming no government default is a guaranteed rate of interest over a multi-decade period.

By contrast cash has income risks during periods of lower interest rates, but is undeniably valuable as a means of ensuring that capital is not at risk.

But in my mind the biggest takeaway should be that we shouldn't oversimplify investing to a set of simple generalisations. These tend to take the view that stocks = risky, cash = safe, bonds = somewhere in between.

In reality I would say that the most risky of these assets would be long-term bonds bought at interest rates of sub 1% - as history suggests that sub 2% is low compared to the historical norm (ie the value of the bond is more likely to fall than rise over the long-term). Equally when your mortgage rate is sub 2% you might as well go for the longest term possible, as long-term it is probably going back up.

The safest assets in my mind would then be long-term bonds bought at interest rates in excess of 10%, which is very high compared to historical norms (ie the value of the bond is more likely to rise than fall over the long-term).

Cash and near term bonds have guarantees of principle, and therefore sit between the two with the least risk in terms of liquidity if you need money to spend. In this sense cash is very valuable as an asset that can be liquidated to cover unexpected costs, but it is worth remembering that the total yield on cash can be lower than alternatives such as stocks and shares so you might pay a big premium for this reduced risk.

In the long-term I still see the FTSE 100 as being the most reliable source of income, since whilst cash might only be paying yields of 2% ten years from now, the FTSE 100 is likely to be seeing steady growth in it's yields over time. 

The very nature of it as a productive asset where you have companies employing people to find new ways of making money is a level of protection, but there are still risks in going all in on this sort of investment as those staff might prove to be incapable of growing income at those companies.

Really though the sweet spot is to understand the different characteristics and to use them accordingly within a balance portfolio. Going all in on cash feels risky if you end up with a lost decade in terms of interest rates, and is not a panacea that will remove income risk. Indeed as we have discussed the income risk to cash savings may be it's greatest weakness as an asset class.