The recent launch of the Lifetime ISA on 6th April 2017 can incentivise savings and encourage you to set aside £4,000 per year.
Here are a few incentives you need to know:
- You can open a Lifetime ISA between the age of 18 to 39;
- There are two specific purposes for it: one is to help towards your home deposit, or towards your retirement;
- At the end of each year, the government will contribute a 25% bonus, that’s £1,000 free money. The amount paid is based on your contribution, which doesn’t include interest, dividends and capital gains;
- That is why the maximum government bonus is £32,000 if you start at 18 and continued to make contribution till you are 50.
However, there is a 25% penalty for early withdrawals. Unless you are 60 years or over. Or, use it towards your first property purchase. Also, there is no penalty if you die!
(P.S. The Lifetime ISA scheme is like every other savings scheme and are subject to change in the future.)
Before We Start
You may ask yourself the following questions:
What is the difference between putting your money in cash or opining for shares?
How much would I end up after 10 years or 20 years, if I make the full contribution?
What happens if the market crashes in one year, how would this affect my overall returns?
And much more.
The post below will try to answer all these questions and more by providing accurate analysis, with tables and charts.
P.S. Please remember these results excludes fees.
Focusing on investing in Stock and Shares in Lifetime ISA
The FTSE 100 has an average return of 6.52%, since inception in 1984.
That is a rise from 1,000 points to the current level of 7,564 points (as of 02/06/2017).
I know there is no guarantee this will continue in the future. But, let assume that it does.
10 Year Period
Using a ten-year timeframe and assuming the FTSE 100 will deliver a consistent 6.52% return. How much would your saving pot be worth?
Your initial costs are £40,000 (£4,000 X 10), but the capital gains and government contribution would have added an extra £27,551.2 to your initial contribution.
This gives you a total return of 68.9%.
Here is a table analysis of your £4,000 contribution:
But, hang on, am I forgetting something here?
Yes, I haven’t forgotten about the dividends!
The reason for not including the dividends is to spot how dividends reinvested contribute to your final total saving pot.
The average dividend yield for the FTSE 100 is 2.92% (1984-2014 data).This takes the average FTSE 100 return of 9.44%.
Applying this, you would be rewarded an extra £37,921.30, which takes your total to £77,921.30, giving you a return of 94.8%.
Here is a table analysis of your £4,000 contribution with dividends added:
So, dividends added an extra £10k to your pocket!
20 Year Period
But, what if we stretch it out further to 20 years. How would that grow your returns?
Extending it would mean doubling your contribution to £80k. And that will give you an extra £125,287.90, which takes your total savings to £205,287.90.
That’s a return of 156.6%.
Here is a table analysis of your £4,000 contribution for twenty years:
Upping the Contribution
That is all good and dandy. But, are we not forgetting something here?
The rise in the costs of living would eat away our purchasing power, meaning a chocolate bar costing 60 pence today, could cost you 90 pence in 20 years’ time.
So, shouldn’t the government be increasing the level of contribution that we could contribute?
Let’s say the government has decided to upped the maximum contribution to £6,000 in the beginning of year 11 but has decided to keep their contribution the same.
So, how would this affect your total savings pot after twenty years?
That extra £20k in contribution would earn you an extra £24,340, giving you a total of £249,627.96.
Leaving you with a return of 149.6%, but that is lower than 156.6%. This is because of the higher personal contribution coming from your end at £100,000.
Here is a table analysis of your £4,000 contribution, which rises to £6,000 by year 11:
The above is done for illustrative purposes and for simplicity. But, the reality of the matter is the government would likely increase your contribution in steady amount like:
Year 2: £4,250;
Year 4: £4,400;
Year 6: £4,750;
And so on.
However, I feel the government won’t be able to contribute more because of the rising National Debt.
So, what about an impending stock market crash?
The Stock Market Will Crash some point in the Next 20 Years
We have been in a bull market for roughly eight years. Therefore, at some point in the future, there will be another bear market correction.
So, let us assume the stock market crashes by 40% in year 8. And, afterwards, it resumes its average rate of return. This is for simplicity reasons.
The reality is a lot different because when the market crashes, a rebound can happen which leads to extraordinary gains for one year!
Again, how would a 40% crash in Year 8 affect your saving pot by the end of year 20?
Well, you would have lost £34,292.40, as your total pot is down to £215,235.56 which means a return of 115.2%.
Here is a table analysis that adds in the effect of a 40% stock market crash in Year 8:
That is a more realistic result than the 149.6% because the stock market does correct itself after a long period of appreciation.
Another assumption I have cut off is that the market can crash more than once. Or, it could do several mini-crashes of 10%-20% in the next twenty years.
On flip-side, there are times when the market would appreciate over 20% more than once. Therefore, the “pluses” and “minuses” tend to trend towards the long-term average returns.
How does the stock market compare to the savings rate?
Right now, the best ISA saving rate is at 1.8% tax-free. But, will this be the case over the next twenty years?
Some people would say yes because the national debt has been rising at a record pace which means an interest rate increase would increase the cost of servicing this debt.
The UK National Debt is projected to come in at £1.73 trillion by the end of 2017. Compared that to 2005, when the National Debt was at £0.5 trillion or in 2011, when it breaches the £1 trillion Pound mark.
However, during this period the UK 10 year gilts have fallen from 4.7% in 2005 to 1%. Lower gilts rate means lower servicing costs.
But, others will point to a gradual rise in interest rate because there is a bubble brewing in the property market, where prices are sky-high.
To satisfy both sides of the arguments, let’s say in the next 20 years the average saving rate is 2.75%.
That rate of return will produce a smaller pot, but how much smaller?
For those “safety first” individuals, your total pot comes to £150,960.10 or 50.96% gain from £100k.
Here is a table analysis that assumes the saving rate averaged 2.75% in twenty years:
That’s £64,000 less if we assume a stock market crash of 40% for one year. Or, £99,000 less, if there is no crash in the stock market.
P.S. The saving rate is for illustrative purposes.
Can You Time the Stock Market?
The reason I am asking the question is that some analysts believe the market are overbought, stating that valuation is above historical averages. While others continue to be bullish.
Take a look at this historical FTSE 100 Index over 20 years.
If you invest back in 1998, when the FTSE 100 trades around 4,300ish points, your capital gains would be less when you bought at the lows in 2009 at 3,460 points. So, does this mean you should time your investment in the stock market?
But, then again how would you know if the FTSE 100 is over or undervalued at any given time?
John Kingham does a great job in drawing up this rainbow chart of FTSE 100 with the CAPE ratio, here:
What it shows is the bubble and depression area of the FTSE 100, based on the top end and bottom end of the rainbow. In hindsight, you could put your contribution into cash between 2000-2002. Afterwards, move back into stocks, up till 2008. Stay in cash for one year, and then move back into stocks, a year later and remain fully invested.
Hindsight is a wonderful thing, but the reality is you would stay invested in 2000 when the CAPE ratio is at 28-32 times. Unless you understand market valuation or know what to look for.
Then, again, would you have sold during 2008’s financial crisis when the CAPE ratio was at 20 times? Unless you understand derivatives and banking, then you probably wouldn’t.
Now, as the FTSE 100 makes new highs, the CAPE ratio is trading close to 16 times. Will you stay invested or would you sell?
The realistic answer is you don’t know because there are too many variables at play!
Don’t forget your brokerage fees
Choosing the right broker is important because some can charge up to 1%, which is ridiculous!
A more reasonable fee is 0.45% from Hargreaves Lansdown. But, I’m there out others that charge less, but may have hidden penalties and rules that are outside the Lifetime ISA.
What if is you can’t decide?
If you feel the stock market is highly valued, then why not put 80% into cash and 20% into FTSE 100.
But, if stocks do correct, then contribute 60%-80% into stocks, this depends on the level of correction.
Hope this explains how the Lifetime ISA works and the difference between investing fully in the stock market or in cash.
If you like this post, then please share with your young friends and family who wants to put excess money aside for the future.
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Thanks again for reading!
This post is in no way endorsing you to invest in a Lifetime ISA or in the stock market. The post aims are to inform and set financial projection that is based on the long-term returns from the stock market.