Where can a poor investor go for a decent return?

In the new world of low interest rates, those 7 per cent savings deals are fading fast. From fixed accounts to ISAs, bonds and shares, Julian Knight sees where you can turn to keep your cash growing

At 2 per cent, UK interest rates are now at historic lows and investors are having to adjust their sights. "The financial services industry used to look at 7 per cent annual growth as a good rule of thumb," says Neil Clarke, director at independent financial adviser (IFA) Lucas Fettes. "But in this new environment, this is no longer as relevant.

"Nowadays, we are looking at a per cent above inflation being acceptable and 2 or 2.5 per cent being very good. Investors, I'm afraid, have to set their expectations lower."

That 2 or 2.5 per cent above inflation, which is currently standing at 4.5 per cent, puts Mr Clarke's new performance target roughly in the 7 per cent range. Crucially, though, most experts reckon that inflation is heading south fast. "If you can get a 4 per cent annual return with security then that is looking good," says Keith Churchouse from IFA Churchouse Financial Planning. "Government gilts, for instance, are paying around the 4 per cent mark, while the return on premium bonds is between 2 and 4 per cent if you enjoy average luck scooping a prize. "

Perhaps the only upside of the credit crunch has been the desperation of banks and building societies to attract saver cash, with some paying over the odds. Only a couple of months ago, that 7 per cent benchmark was easy to achieve through fixed-rate and regular saver accounts. But since the Bank of England cut the base rate by 1.5 per centage points in November, savings deals have come off considerably. In most instances, reports financial information firm Moneyfacts, rates have fallen by 1.5 per cent. With the Bank having cut again, the good days could soon seem a distant memory.

"By the middle to end of next year at the very latest, savings account rates – and their premium over the base rate – will be a lot lower. The banks are building their deposit levels and once that's done there will be no reason to pay the rates they do now," says Anna Sofat from IFA Addidi Wealth, adding that the smart money is on returns being in the low single digits.

Financial experts reckon that the best play under these circumstances is to buy into fixed-rate savings accounts, though there are a couple of provisos. First, many of these deals impose restrictions on access, so only put your money in if you are sure you won't need it in a hurry. Second, the fix usually only lasts for a relatively short period – a year, say – and after this, the rate will often revert to a lower level. Moneyfacts says best buys include Principality building scoiety's one-year fix paying 5.76 per cent and Anglo Irish Bank at 5.75 per cent.

In the long run, savings accounts are unlikely to deliver growth well above inflation, never mind reaching the magic 7 per cent: "Looking over 10, 15 or 20 years, savings on average deliver just above inflation," says Ms Sofat. "But this pales compared to the long-term performance of shares."

However, she adds that money held in a cash individual savings account will increase returns as interest is paid free of tax. Up to £3,600 can be saved in a cash ISA each year. "You always have to factor tax into the equation," explains Ms Sofat. "For example, the three- and five-year, index-linked bonds from National Savings & Investments offer to pay 1 per cent above inflation. That's OK, but when you realise that this is tax-free, suddenly the returns are much more attractive."

Despite substantial falls on the stock market over the past 18 months, advisers still push the idea of share investment as a way to achieve above- inflation growth – though investors should be cautious, says Mr Clarke at Lucas Fettes. "Over the long term, I still think it will be the case that share investment does better than savings accounts. But if you're buying individual company shares then look at firms in 'defensive' sectors, which pay a dividend. If you're earning a 4p or 5p dividend in the pound, that's a very good return in the new low interest rate world." Generally, defensive sectors include staple foodstuffs, arms, pharmaceuticals, mining and oil.

But Mr Clarke adds that younger investors with time on their side to make good any short-term losses should look east for returns. "Markets in the emerging India, China and Pacific economies offer the prospect of good long-term growth; unit trusts investing in these areas could give you a chance of beating 7 per cent. However, as we have seen in the past year, there are also substantial risks, at least in the short term."

Further tax advantages are available if you buy shares and other investments through a self-invested personal pension. "With Sipps, higher- rate taxpayers get relief on contributions of 40 per cent, and what's more they are flexible as you can take 25 per cent of the pension pot as a tax-free lump sum at age 75 and you don't have to use the money invested to buy an annuity until 75 or after," says Ms Sofat.

Outside shares and savings, IFAs are turning to bonds, some of which pay around 7 per cent. "Many good companies are paying a high yield now," says Dean McCarthy at Cobalt Capital. "This means there are lots of bargains as bond markets are overpricing the effects of the recession. Some are figuring default rates will be as high as in the great depression; I don't think that's going to happen."

Even government bonds, or gilts, once a Cinderella investment favoured only by ultra-safe individuals and pension funds, are starting to pay more and may have to raise that rate in future because of the UK's burgeoning national debt. "Some gilts are paying around 4 per cent and that's pretty good," says Mr Churchouse. "One consequence of the Government needing more debt is that it will have to attract more investors."

But Colin Jackson, director of IFA Baronworth Investment Services, reckons that by boxing clever you get more than 4 per cent. "You have to take a little risk but not too much to get a reward. There are so-called 'structured products' out there that pay an income of 7 to 7.5 per cent a year provided the stock market doesn't crash or there is a mass failure among insurance companies," he says. "If, like me, you think shares have fallen too far and view a collapse of insurers as very unlikely, then these structured products offer an interesting option.

"Just bear in mind that it's a good idea to have a spread of investments – savings, shares, bonds – alongside more specialist products."

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