As the end of each tax year draws nearer, people rush to top up their ISAs in order to take full advantage of the current year’s ISA allowance. But why wait until the end of the tax year? Why not check notice periods on any money currently tied up so that you can prepare now to invest in a new ISA? Putting money in an ISA at the end of the year potentially marks a year of tax-savings lost. Instead, maximise your tax efficiency and make the most of compound returns by putting money aside at the beginning of the tax year. The ISA allowance for 2012-2013 will be £11,280, up to half of which can be in cash.
As Fidelity’s Head of UK Personal Investments Rob Fisher has pointed out, ISAs and pensions can comfortably sit side by side. Consider your pension your ‘locked box’ of savings and your ISA your ‘unlocked box’—though you don’t want to withdraw assets unnecessarily it’s comforting to know that you can if you need to.
There are numerous strategies for making the most of ISAs and pensions. Below we investigate some of the most common strategies using food analogies (apologies to our vegetarian readers!) We also provide some key pointers for each strategy. By no means is this an exhaustive list, so we recommend you seek professional advice if not entirely comfortable with your investment goals or how you’re going to achieve them.
Scenario 1: My ISA is My Meat
It may be that ISAs represent your first or only foray into the world of investing, in which case you want to ensure you build up a diversified portfolio with a solid core fund at the centre.
A diversified large-cap fund can often serve as a core stock holding in a portfolio. Knowing that your portfolio includes a rock-solid core can help you better cope with the extreme volatility that has plagued the market in recent years. Why large caps? Typically a core stock holding is a large-cap fund because the market is made up of mostly large-cap stocks. Given that small caps have outperformed large over very long time periods, a question that naturally arises is "Why does my portfolio have to look like the market with all those lacklustre large caps?" But large caps tend to be steadier over extended periods of time than smaller stocks, giving investors the courage to stick with them through the rough patches. In short, they tend to be solid businesses with steady profits that compound your money decently over time.
Other considerations when picking your core fund holding are fees, management and indexing. Firstly, although it may not seem like a big difference whether you're paying 1% or 2% as an expense ratio, fees cut into returns dramatically over time. Additionally, even if the stock market returns 8%-10% in the future keep in mind that inflation has historically run at more than 3%, meaning that stocks have increased your purchasing power by only 5%-7% so every percentage point counts when it comes to trying to beat inflation, as do expense ratios. Secondly, if you’re picking an actively managed fund then look for an experienced manager with a strong track record. Thirdly, consider an index fund such as a tracker or an ETF. These are generally low-cost—some ETFs offer fees close to zero, they virtually guarantee you the index’s return, and you won’t have to worry about management or strategy changes. Want to know more about ETFs? Read on here.
Scenario 2: My ISA Is the Veg To Complement the Meat of My Pension
Another plausible scenario is that you may have already retired and you use your ISAs to reinvest income, take natural income, or make withdrawals if you need to without impacting your tax status.
“In some cases I think people can be a little bit guilty of not using their ISAs in the way they’re intended, i.e. they’re not actually taking withdrawals,” says Fisher.
Starting the retirement phase of your life doesn’t mean you’re about to kick the bucket—in modern Western society on average you’ve got at least a decade ahead of you and in many cases up to three decades. So having a mixture of assets across your investments is important.
“If you’re living for another 20 years you still want to be partly geared towards equities or perhaps higher risk investments, as you still need some equity growth in your portfolio to keep the real value of your money ticking over,” Fisher says. Of course it’s worth keeping in mind that inflation is on the rise as well as taxes so investors also need to figure this into their portfolio. “Typically having some exposure to equities and equity income, which is able to grow over time alongside other asset classes is quite important,” Fisher adds.
Scenario 3: My ISA Is a Dessert that I Enjoy as an Extra Treat
Our final scenario is one in which you may be comfortable that you are suitably invested to achieve your goals but you still want to put any extra cash to work, ideally in a more ‘exciting’ fashion. In this case you may want to supplement your pension’s diversified and targeted portfolio by putting higher risk and greater-income-generating investments in ISAs, where their income and gains will be tax free. If it’s excitement that you’re seeking and you want to run a ‘mad money’ account then an ISA can be a good way to limit you pot and ensure it’s kept separate from your nest egg.
Here at Morningstar we’re fans of investing, i.e. trying to put money where the odds of earning a good long-term return are stacked in one’s favour, rather than speculating, i.e. buying an asset in the hope of big short-term gains or making a call on the short-term direction of the market, individual stocks, or commodity prices. But if you must gamble, then be sure to read our archived article Speculate Without Losing Your Shirt.
In all cases, if you are running two portfolios side by side make sure you’re looking at the big picture. Use Morningstar.co.uk's Instant X-Ray tool to identify any stock overlap, review your overall asset allocation, and see which areas of the market you may have above-average exposure to.
Whichever strategy you opt for, Fisher is a strong believer in the ‘locked’ and ‘unlocked’ approach: “Having the flexibility of ISAs alongside the benefits of having some money in a pension is a good target place to be—they really complement one another quite nicely.”
For more information about investing in ISAs for the 2012-2013 tax year, read "Your 2012-2013 Guide to ISA Investing".
