Three Generations: ISA Investing

ISA Investing - Three Generations - Children, Parents, Grandparents 

Individual Savings Accounts (ISAs) are truly efficient savings and investment vehicles for all generations – you can save into them at any age. You don’t get the tax breaks at the outset that you get with pensions, but you do get your investment back tax-free on withdrawal.

The deadline for investing your ISA allowance for the tax year 2022-23 may have passed, but now is the time to consider whether you have monies available to lump sum invest, or can start to make regular contributions. After all, the sooner you start investing, the longer your investments have to build up.

Here, we explore the reasons for and best ways to consider saving into an ISA to age 18 (clearly with some assistance in the initial stages), then from 18 to age 50, and finally from age 50 plus.

Investing from birth

There are compelling reasons for any of us to save and invest, and that includes engaging children from an early age in saving and investing, as well as investing on their behalf as parents, guardians and grandparents. Given the longer time horizon, by investing in early years there is scope for more adventurous, longer-term investing – more risk could be taken because there is time for any volatility in the market to be balanced out.

For children, the long-term, tax-free savings option is a Junior ISA (JISA). Children must be under 18 and living in the UK, and the annual limit is £9,000 for 2023-24. The JISA can be in either cash or stocks and shares, and no tax is levied on the interest on cash in the former, or on capital growth or dividends under the latter. While the account is opened by parents or guardians and managed by them, the money in it is effectively owned by the child. They can take control of the account when they are 16, but can’t withdraw any money until they reach 18.

Jason Hollands, managing director, corporate affairs at Evelyn Partners, says, “Most children are going to have limited capacity to save themselves, other than store up some pocket money. But parents and grandparents will often want to put some money aside on their child or grandchild’s behalf to help give them a financial head-start in life, either to help cope with the costs of a future degree, or building a pot that could help with a property deposit.”

The Association of Investment Companies (AIC) has highlighted that over the past 18 years, a one-off investment of £1,000 in the average investment company would now be worth £6,089 (a 509% return) or an annualised return of 9.9%. If monthly contributions had been made instead, eg £50 per month, the total investment of £10,800 over 18 years would be worth £28,810.¹

Annabel Brodie-Smith, communications director of the AIC, says, “Investment companies benefit from the long-term growth potential of the stock market. They offer a way to spread investment risk through a diversified portfolio of investments. Over longer periods, investment companies have delivered strong performance.”

Where to invest

Too often JISA savings go into cash accounts, rather than stocks and shares. “Cash is a terrible place to park wealth for long periods of time, as the real value just gets chipped away by the silent assassin known as inflation,” says Hollands.

For those saving for a child for long periods, it is much wiser to choose a well-diversified investment, such as a fund or investment trust predominantly focused on equities, and to cast your net widely by taking a global approach, rather than narrowly focus on one or two markets, he says.

“Some global funds and trusts invest across both the developed world and emerging markets, so can provide a one-stop-shop for investors, but another option is to invest into two separate funds – one investing in developed markets, the other across emerging markets – with the latter representing a smaller part of the JISA.”

Ben Yearsley, investment director at Shore Financial Planning, agrees. “Invest in equity, equity, equity,” he says. “You get so many taking a cautious approach for kids, which in my view is entirely the wrong thing to do – they've got time and therefore you want risk. Definitely forget cash – especially if they are under ten!”

How not to blow it

One of the qualms often felt about JISAs, is that parents fear that when children have access to their savings at 18, they could blow the lot on travel, festivals or big nights out.

Hollands suggests an alternative: parents can simply make use of their own ISA allowance and then choose to gift money from it as and when they wish, or directly pay for certain items – such as tuition fees – to help the child out, while themselves retaining full ownership and control. And parents can also save money for their children into a fund that they can’t get their hands on until they are much older – into a pension.

“Many people are not aware that it is possible to do this,” says Hollands. “Gross pension contributions of up to £3,600 (meaning an actual cash contribution of £2,880 net of tax) can be made for a child each year, and although the child is probably earning nothing, they will still benefit from tax relief, with the pension being topped up by as much as £720 of ‘free money’ in respect of basic rate tax. The idea of doing this may seem strange, given the child won’t be able to access this money until they retire, but the combination of early investing, the boost provided by the state top-up and compound growth over decades, is a very powerful argument indeed.”

If someone contributed the maximum to a child pension each year for 18 years, he says the cash cost would be £51,840, with £12,960 of top-ups added by the state. If the investment grew at a compound annual rate of 5%, then the value of the pension pot would be worth £1.23 million by the time the child reached 65.

Investing from age 18 to age 50 

From 18 upwards, individuals have many calls on their finances – they may be about to take on student debt, or pay rent for the first time, they may be saving for a mortgage. For the latter, there is the Lifetime ISA, which can be used to buy a first home. Individuals must be over age 18 and under age 40 to start saving. The annual limit is £4,000 until age 50, and the government will add a 25% bonus to any savings, up to a maximum of £1,000 per year.

Stocks and shares and cash ISAs, or innovative finance ISAs, can be held in conjunction (age restricted) with a Lifetime ISA, and with the overall annual allowance of £20,000.

Stocks and shares ISAs are susceptible to stock market fluctuations as with any investments; cash ISA interest rates need to be referenced against other savings rates and growth may be less than equity returns, and innovative finance ISAs are considered higher risk, as you are investing in loans effectively (peer-to-peer investments) which could be defaulted on.

Because of the life events that lie ahead – starting to earn, buying property, changing jobs, having children – individual requirements will change hugely, as will the time scale for saving and investing. As Hollands says, before choosing an investment, it is really important to first of all consider your goals and the broad time horizon you expect to be investing for.

“This is really key because, in the world of investing, there is a relationship between risk and reward, and the longer you expect to remain invested, the greater the level of risk you should be prepared to tolerate because there is more time to recover from any market volatility setbacks on the way,” he says. “As investors were reminded last year, financial markets don’t relentlessly move upwards all the time, they can be volatile, and everyone should expect to encounter the occasional down period during their investing lives.

“It’s often assumed the younger you are, the more time you have, and therefore more risk can be taken. However, that isn’t always the case, and so I would urge people to think of the time horizon between now and when they need to use their investment pot for a particular goal, rather than just make assumptions based on their age.”

As an example, Hollands says while someone in their 20s may have a 40-year time horizon if their goal is to build up a pot for retirement if their aim is to build up a deposit for a home, it could be a relatively short one, which will require a less risky approach.

Where to invest

An individual’s goals therefore may well direct where to invest. But if capital growth is a key aim, a longer-term horizon will inevitably be required.

Geographically, a global approach will also help. Yearsley says, “For long-term investors I look to Asia. It’s had a lacklustre few years, mainly down to Covid-19 lockdowns in China. But with China re-opening, that should provide Asia a timely boost.” In terms of sectors, Yearsley would look at ones like technology. “It's not been the best in the last year, but tech is still crucial for the long term,” he says. “Healthcare is another long-term growth area and it’s an unloved sector. Ageing populations are a key driver.”

It is hard to eschew the benefits of equity investment, diversified over the long term. “While equity markets can be volatile over shorter-term time periods, over the long term they have historically both outperformed cash savings and beaten inflation,” says Hollands.

“When it comes to investing, diversification is an important principle, helping to both reduce risk and broaden exposure to a wide range of opportunities. That can mean spreading your ISA investments across a range of asset classes such as equities, bonds, commodities, infrastructure, property and cash, as well as different regions and industry sectors.”

Diversification should also apply to when investment returns are required, with a mix of riskier stocks for long-term growth, and lower risk for nearer-term requirements.

“Very long-term investors should be prepared to take more risk, as they have more scope for recovery from any setbacks on the way, while those with a shorter time horizon should take a more defensive approach, to avoid seeing their investments plunge on the evening of needing to cash them in,” says Hollands. “The main consideration here, is how much exposure investors should have to equities – the highest returning, but also most volatile, of the major asset classes – versus less erratic ones such as bonds and cash.”

Diversification also matters when it comes to exposure to different regions and sectors, Hollands adds, advising investors not to take too narrow an approach focused on just one or two markets.

“Global investing is very easy, as there is an abundance of global funds and investment trusts available, as well as ones that specialise in different regions such as the US, UK, Europe, Japan and Emerging Markets, which can be blended together,” he says.

When it comes to dividends, whether they should be reinvested or serve as income depends again on an investor’s immediate requirements.

“It depends whether you need the income,” says Yearsley. “If you don't need income, then reinvested dividends provide a great mechanism to enhance your total return. You can always reinvest to start with, then take the dividends later in life.”

Is it worth it?

Annually, investment platform Interactive Investor (ii) publishes its ISA millionaires data. At the end of January 2023, it had 852 ISA millionaires on its books.

Investment trusts account for 42.5% of ISA portfolios’ holdings for these ISA millionaires, compared to 8.2% for funds.

Dmitry Lipski, head of funds research at ii, says, “It’s no surprise to see investment trusts take up such a large proportion of customer portfolios. Over the long term, some unique features such as gearing (borrowing) to enhance returns have helped them deliver strong long-term returns overall. Over time that might mean that they start to account for a larger percentage of a portfolio. Some investors might consider rebalancing, particularly if a very adventurous investment trust is suddenly taking up a big share of the pie due to outperformance.

“Investment trust bells and whistles mean they can also underperform in a falling market, and because they are listed on the stock market, trusts can also be impacted by sentiment. But the data shows that investment trusts should not be overlooked.”

While blue-chip stocks are high up ii’s list of ‘millionaire’ holdings, global investment trusts Alliance Trust and Scottish Mortgage were top and third, respectively, in the top picks for investors, with Shell at number two and BP at eight.

ii says that were investors to start now and invest the full £20,000 annual ISA allowance (assuming it stays the same), and investments saw 5% annual growth excluding fees, it would take 25 years to reach the £1 million mark, or £1,002,269.08. If investments grew by 7% net of fees, investors could get £1,048,722.82 in 22 years. With an annual growth of 3%, it would take 31 years to reach £1,030,055.17.

Investing from age 50 plus

With people now often being retired for longer, there is less of a focus on lifestyle investing in ‘safe’ options such as gilts and bonds as retirement approaches. Investors need to ensure income and growth – how to preserve capital and pay for living expenses.

“It is often argued investors should reduce risk within both their pensions and ISAs in the run-up to retirement, by gradually cutting exposure to equities in favour of steady eddy and less risky bonds,” says Hollands. “While there is good logic to taking less risk as your time horizon shortens, it can also be a mistake to reduce equity exposure too early. That’s because improved lifespans mean that many people could be set to live for 20 to 30 years in retirement, and will therefore need to see continued growth in the value of their investments to keep ahead of inflation. Exposure to equities is one of the best ways to achieve this, especially in respect of dividend payments, which have the potential to grow over time. This is where ISAs can be particularly important, as both dividend income and interest from bonds and cash is tax-free.”

The dividend divide 

The fact that one doesn’t pay tax on dividends from shares in an ISA is a compelling consideration, given the allowance above which tax will be levied on dividends is falling from £2,000 to £1,000 from 6 April this year, and then further to £500 from 6 April 2024.

There is a way to ISA your dividend tax liabilities, by selling shares or funds and then buying them again within an ISA – this is called ‘Bed and ISA’. Depending on personal circumstances there may be a capital gains tax liability, and there may be transaction costs.

If you are looking for regular dividend income, there are the 18 ‘dividend heroes’ – the investment trusts that the AIC highlights for having increased their dividends for 20 years plus, and some for over 50 years.

These include the City of London, Bankers, Alliance Trust, Caledonia Investments, Global Smaller Companies Trust, F&C Investment Trust, and Brunner.

Given the recent hits from falling stock markets that savers have had on their savings and investments – with the additional concern of rather hoping they would be utilising them sooner rather than later – Annabel Brodie-Smith at the AIC says, “Investors are looking for ways to protect their income in a more inflationary environment. Investment companies’ ability to hold back up to 15% of the income they receive each year, gives them an edge when it comes to delivering dividends to investors. It means investment companies can reserve income when times are good to pay out in leaner years, providing smoother, more consistent dividends to investors.”

1. Performance for the average investment company is the % share price total return for the weighted average investment company (excluding VCTs). 18-year performance is from 01/11/2004 to 25/11/2022. Source: www.theaic.co.uk & Morningstar.

Mark Atkinson is senior director, client management, wealth & retail at Alliance Trust

This information is for informational purposes only and should not be considered investment advice. Past performance is not a reliable indicator of future returns. The views expressed are the opinion of the Manager and are not intended as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell any securities. The views expressed were current as at April 2023 and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

TWIM is the authorised Alternative Investment Fund Manager of Alliance Trust PLC. TWIM is authorised and regulated by the Financial Conduct Authority. Alliance Trust PLC is listed on the London Stock Exchange and is registered in Scotland No SC1731. Registered office: River Court, 5 West Victoria Dock Road, Dundee DD1 3JT. Alliance Trust PLC is not authorised and regulated by the Financial Conduct Authority and gives no financial or investment advice.