Reforming ISAs

This short report explores the potential for reforming ISAs (individual savings accounts) in the context of the government review of ISAs and its ambition to widen retail participation through the development of a broader culture of investment. It outlines four options for reform, the rationale for them, and the potential impact they could have. For anyone who wasn’t already aware, ISA reform is an emotive topic. This paper will no doubt upset lots of people. But we think any of these reforms (all of which would only affect a small minority of people who use ISAs today) would be a big improvement on the status quo, and some of them - in combination with other measures - could help have a significant impact on the future financial security of millions of people in the UK and deliver a much-needed boost to the UK economy.

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Here is a short summary of the report:

A headline success: 

ISAs are an important part of savings and investments for millions of people in the UK. ISAs have evolved over the past 25 years into a hugely successful tax-free savings and investment account with nearly 12 million people putting over £80bn each year into cash savings or investments on average over the past five years. The combined assets across more than 22 million ISA accounts add up to around £775bn (more than the total value of defined contribution pensions assets).

Resetting the balance:

But ISAs have become increasingly complicated (with a range of four to six different types of ISA, depending on how you count them), they are uniquely generous compared with similar accounts in other countries, and they may have decoupled from their original purpose. Cash ISAs have arguably become too successful and may be encouraging too many people to save too much, when investing part of these savings instead might be more beneficial to them over the longer term. Stocks & shares ISAs have arguably not been particularly successful in building a broad-based investment culture despite the uniquely generous tax breaks they offer (with less than 6% of the adult population paying into them each year).

Aligning incentives: 

The closer you look, the more it seems that ISAs have become distorted. Nearly three quarters of the money going into ISAs each year comes from just a quarter of users who are able to put in more than £10,000 a year. The majority of money being put into ISAs seems to be coming from the transfer of existing savings and investments (or from savings and investments that would otherwise have been made without the tax incentives on offer) rather than from the formation of new savings and investments. It is not immediately clear why the government should provide such generous tax relief (of around £8bn a year) to repackage existing savings and investments above £10,000 a year.

The case for reform

We think there is a strong case for building on the success of ISAs by simplifying and reforming the ISA framework and realigning it with its original aims. While structural reform will not solve the problem on its own, we think it is an essential starting point. Given the success of ISAs, it will be important to keep any reforms as simple and intuitive as possible, and to ensure that any changes do not affect the majority of users. On that basis, this report outlines four options for reform. Our proposals would only affect the minority of people in the fortunate enough position to be able to put more than £10,000 a year into their ISA.

1. The simple option: simplifying the complex range of ISAs into a single account called an ISA (‘investment and savings account’, rather than ‘individual savings account’) to encourage and enable more people over time to start investing.

This would not negatively affect any subscribers to ISAs. Over time, we estimate it could encourage an additional 2.7 million people who currently use cash ISAs to invest an additional £5.4bn a year and could also encourage more people to start using ISAs.

2. The cash option: capping the annual allowance for cash ISAs at £10,000 to encourage people who currently save more than that to put some of the balance into investments.

This would not affect the 80% of cash ISA users who currently save less than £10,000 a year into a cash ISA and would not affect subscribers to stocks & shares ISAs. Over time, it could encourage more than 700,000 people who currently save more than £10,000 a year into their ISA to invest an additional £3.8bn a year.

3. The balanced option: simplifying ISAs into one account and capping the annual allowance for cash ISAs at £10,000: subscriptions up to £10,000 could be saved in cash or invested, but subscriptions above £10,000 would have to be invested to qualify for the tax breaks.

This would not affect the 80% of cash ISA users who currently save less than £10,000 a year into a cash ISA and would not affect nearly 90% of the people who currently subscribe to cash ISAs or stocks & shares ISAs. Over time, it could accelerate a shift towards more people who currently use cash ISAs investing and encourage up to 2.7 million people to invest an additional £5.4bn a year, as well as encouraging more people to start using ISAs.

4. A UK mandate: the same as option three, but any subscriptions above £10,000 a year would have to be invested in UK equities (or other UK assets) as a quid pro quo for the unusually generous tax relief on ISAs. As an additional incentive, this could also be combined with abolishing stamp duty on UK shares held in ISAs, or abolishing stamp duty on UK equities trading altogether.

This would not affect nearly three quarters of people who currently subscribe to ISAs: it would not affect the 80% of people who currently save less than £10,000 a year into a cash ISA, and would not affect the nearly two thirds of subscribers to stocks & shares ISAs who currently invest less than £10,000 a year. This could lead to a net increase in investment in UK equities of around £10bn a year.