The real secret to becoming an ISA millionaire
Pensions and ISAs should be the first two places to build up savings, but it takes time
One of the slightly irritating features of the run-up to the end of the fiscal year on 5 April is the plethora of adverts about ISA millionaires. The implied pitch is simple: you too can become an ISA millionaire if you fill out a form and send a cheque – or rather quite a few cheques.
The reason is simply that the annual allowance for how much can be put into an ISA cannot be carried over into the next tax year, so there is a spur to do it now. That’s useful because we all put things off, but there is no magic path to millionaire status. The path is to save money while young and rely on compound interest to build up the capital. An ISA, or an individual savings account, is one of two main ways of doing so efficiently. The other is a pension plan.
A column like this is not the place to advise people how to manage their finances. Everyone has different financial aspirations, different incomes and different family circumstances. What is worth pointing out, however, is that anyone wanting to put aside money for their future should be aware of three things.
The first is that taxes and charges whittle away the returns, making savings build much more slowly than they otherwise would.
The second is that there is something that people can do to minimise these headwinds, and in one regard, turn them into tailwinds.
And the third is over a very long period, investment brings positive real (ie after inflation) returns, with the result that becoming a millionaire at today’s prices should be attainable for most people.
A word about each.
In a world of high inflation and high interest rates all investment returns are pulled upwards. If, say, interest rates are 5 per cent and other investment returns a bit higher, an investment management charge of 1.5 per cent might seem not too bad. But if rates are near zero and government bond yields 1.5 per cent, you stand still. All the return goes to the manager, which makes no sense at all. Finding managers with low charges really matters.
As for taxes, you have to pay income tax that knocks off 20 per cent or 40 per cent before you put aside the money, and you probably pay tax on most of the interest or dividends. If you make a capital gain above a threshold, even one that is simply matching inflation, you pay yet more tax. Straightforward saving is deeply discouraged by our tax system, which is why successive chancellors have had to create loopholes to encourage people to save. (The UK has, I am afraid, one of the lowest savings rates in the developed world.)
That leads to point two. The two loopholes are ISAs and pension plans. Since an ISA allows people to hold cash, shares, and unit trusts free of tax on dividends, interest, and capital gains, there is no headwind from taxation. But you still have to pay income tax on the money before you put it in. Pension plans get round that because you pay the money before tax, not after it. In addition, employers bump up your contribution, so saving via a pension is a no-brainer.
Because that is so attractive the government has all sorts of limits on how much money you can put in, when you can take it out, and the size of the pot you can accumulate. But pensions and ISAs should be the first two places to build up savings.
Now, where should that money go?
We know a lot about investment returns, for there is a database that goes back to the 19th century. I have been looking at one of the best studies of long-term investment returns, which is carried out every year by Credit Suisse Research Institute and the London Business School. Its latest report came out last month.
Last year, as most of us are aware, was a very poor year for shares, but allow for that (and a couple of world wars), and over the past 119 years, shares have still been the best investment. They have returned more than 5 per cent in real terms. If you are in the fortunate position to be able to put £20,000 into an ISA every year, and the average return is 5 per cent, after 24 years the pot would be worth just under £1m – and that is in today’s money.
Can’t afford £20,000? Put in £10,000 every year and you would take 35 years to get there. Put in £5,000 every year and it takes 47 years, which does seem rather a long time. But you see the point: becoming an ISA millionaire is not so outlandish after all. It just takes a while to get there.