Speculation is mounting that the chancellor will slash the cash ISA limit in next week’s Mansion House speech, to the dismay of millions of savers.
Rachel Reeves is said to be considering cutting the cash ISA allowance, possibly to as low as £4,000 or £5,000. Currently, savers can put up to £20,000 into a cash ISA each tax year, and earn interest tax-free.
A drastic reduction in the limit means many people will have to pay tax on some or all of the interest on future savings; higher earners face having a 45% chunk siphoned off by HMRC.
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However, you may not need to worry too much about a reduced cash ISA allowance. That’s because it is possible to generate tax-free, cash-like returns without a cash ISA: you buy a money market fund within a stocks and shares ISA instead. Many of these funds are currently paying an income of more than 4%, or even 5%.
Mark Burges Watson, co-founder of the money app Kaldi, told MoneyWeek: “If the chancellor cuts the cash ISA allowance from £20,000 to just £4,000, many savers will be left wondering what to do with the remaining £16,000 of their tax-free allowance - especially if they’re not comfortable taking on stock market risk. But there’s a solution that few people are talking about: money market funds.”
The funds have become popular with investors since interest rates rose, after years of low returns. And now they’re enjoying another moment in the spotlight as rumours swirl of a cash ISA limit cut.
Indeed, the Fidelity Cash Fund is Fidelity’s best-selling fund this year. At Interactive Investor, the most popular money market fund on its platform is the Royal London Short Term Money Market – which has also topped the list of its most-bought funds for over six months.
So, how do these funds work exactly? What sort of income do they pay, is it guaranteed, and what are the risks?
What are money market funds?
Money market funds - also known as cash funds - are a type of investment. This means they can be held in a stocks and shares ISA, pension or general investment account. They are low-risk and their returns are designed to track UK interest rates. So, in that way they are similar to a traditional savings account or cash ISA.
Andrew Prosser, head of investments at InvestEngine, said: "A money market fund is typically made up of short-term debt from governments, banks and companies with strong balance sheets and investment-grade credit ratings.This means they offer relatively stable, if slightly lower, returns compared to other types of investments. But most importantly, any returns invested through an ISA are tax-free.
"With interest rates still well above 4%, these types of funds are becoming more popular and can be seen as a substitute for a savings account. Savers can invest in money market funds through their stocks and shares ISA - and they can, if they wish, hold their entire £20,000 annual allowance in just one fund.”
How much can I earn with a money market fund?
The funds produce an income, known as the yield. This is not guaranteed, and it can fluctuate.
According to Laith Khalaf, head of investment analysis at AJ Bell, money market funds are currently offering “decent yields”.
The five most popular money market funds with DIY investors on the AJ Bell platform are:
- Abrdn Sterling Money Market (historic yield 3.9%)
- Fidelity Cash Fund (4.8%)
- Legal & General Cash (4.8%)
- Royal London Short Term Money Market (5.3%)
- Vanguard Sterling Short Term Money Market (4.7%)
“This yield is the income produced by these funds over the last 12 months, and it is variable, so there’s no guarantee these will be matched over the next 12 months. Indeed, with interest rates waning, the yield on money market funds will also likely get trimmed in the coming year too,” added Khalaf.
You can also get money market exchange traded funds (ETFs). InvestEngine offers Xtrackers GBP Overnight Rate Swap and Lyxor Smart Overnight Cash, both at a cost of 0.1% total expense ratio. These funds track the Bank of England’s Sterling Overnight Index Average (SONIA), which is currently about 4.2%.
Are money market funds risk-free?
No, they are not risk-free. The yield can fall, and occasionally returns can turn negative.
Khalaf said: “During the years of very low interest rates, some money market funds made slightly negative returns, reflecting the fact that the interest collected was so small, it was more than offset by charges.
“During the financial crisis some of these funds saw their value falling more substantially, because there was a high degree of uncertainty around banks’ solvency. That was an extremely rare event, and since then regulations have been tightened up to try to prevent a repeat of the systemic contagion we saw in 2008.”
According to Burges Watson, “many institutions stand behind their money market funds and paper over any tiny losses” because of the risk of the fund being liquidated by the regulators.
He added that “the main thing is that in a full-blown financial crisis they are not covered by the £85,000 government guarantee”, which is provided by the Financial Services Compensation Scheme. In contrast, the scheme would cover savings accounts and cash ISAs if a bank or building society collapsed.
Can I put my whole ISA allowance into a money market fund?
Yes, you can put your entire ISA allowance into one or several money market funds. Or, you could keep your cash ISA at whatever the maximum level is - say, £5,000 if Reeves decides to lower it - and then open a stocks and shares ISA and invest up to the remaining £15,000 (if the overall ISA limit stays at £20,000) in cash fund(s).
It’s possible there may be some change to that if the cash ISA limit is cut. However, this is unlikely as it would be difficult to exclude short-term fixed interest investments from being held in a stocks and shares ISA.
Bear in mind that if your goal is to grow your wealth you may want to consider investing in the stock market - and therefore buy shares or equity funds with your stocks and shares ISA - as this could give you higher returns. However, this is riskier than keeping your money in cash and money market funds.
For savers wanting to stay in cash - or cash-like investments - Sam Benstead, fixed income lead at Interactive Investor, said: “The strict investment rules mean that returns between money market funds tend not to vary too much, and that funds do not stray into higher risk assets.
“Yields are normally just above the Bank of England interest rate, currently at 4.25%, which can often be more competitive than a regular savings account.”
Is there another way to invest in cash using a stocks and shares ISA?
Most investment platforms allow customers to “park” their money in cash before deciding where to invest.
So, if you’re a new investor wondering how to allocate your money, you could leave it in cash earning interest while you decide.
Interest rates vary a lot, as our investigation into interest rates on investment platform cash balances reveals.
Some pay just 1% or 2%, while others, like AJ Bell’s Dodl ISA pay more (variable cash yield 4.32%). Bestinvest and Trading 212 also tend to pay competitive rates of interest.
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