Upon skimming through the 2016 UK Budget, there are lot of interesting points of discussion (at least to me), however, one of the most interesting on this first read through is the Lifetime ISA, which makes a debut in April 2017. For anyone who is not from the UK, an ISA is an “individual savings account” and presents the average British saver with a tax-free savings vehicle. Various ISAs are structured in different ways.
The immediate thing that stands out here is that the UK Government is promising British citizens up to 1,000 British Pounds yield on savings of 4,000 Pounds. That’s 25%! This sounds like fantastic news for the average citizen- so why does this yield scare me senseless?
Well, put simply, there is no such thing as arbitrage (risk-free yield). Finance majors with a heavy academic slant, will of course argue the contrary: What about Triangular Arbitrage? High-Frequency Trading? Put simply, if you think you’ve found an arbitrage opportunity, you either aren’t fully understanding the risks (yet) or you are talking about something with a very low risk to reward ratio- which of course, may not remain in place for very long.
Anyway, armed with this information, it should be obvious to even the most basic investor that sitting on a low-risk investment which returns 25% per annum is quite literally too good to be true. This sounds like the financial equivalent of the UK Govt. promising everyone an elixir of eternal youth. Or maybe the equivalent of one of those shady web ads. offering an investment strategy which is “guaranteed to turn you into an overnight millionaire!”
So where’s the catch? It’s easy enough to make make a 37% return swing-trading a volatile asset, over a month or two (and I have), but the explicit understanding is that there are serious risks assumed in doing so and the losses can mount up faster than the gains. Anyway, I’ll discuss the risks and likely aims and risks of this investment scheme below:
What is the purpose of the ISA?
There are likely to be four broad aims with this ISA being floated:
- Recapitalize the banks at a time when banking is quite a weak sector.
- Increase savings rates of individuals in a country which is running out of steam as a global consumer.
- Ween the population off of public pension schemes and ensure they save for their old age (because, like it or not it’s coming and “pensions won’t be there when you get old, pleb.”)
- Shift under-the-mattress cash savings into the electronic banking system.
These are fairly self-explanatory. Nothing more needs to be said here other than the first and last points being heavily related. (See my writings on the global transition to electronic currency here and here.)
So where is the risk?
Well the first two points above highlight potential risks, one directly and one indirectly. Banking is weak, and in any market which is in systematic decline, it stands to reason that not all market participants will emerge unscathed. There is a risk of failure and loss of wealth. This is just a normal function of fractional reserve banking which is an inherently unstable system from a mathematical perspective. To put this into real world context I know a guy who receives a 15% interest rate on several corporate bonds he holds with a local bank. The caveat of course is he is from Argentina, and the bonds were floated (with a short time horizon to buy into them- about 48 hours) during a banking crisis.
The second point is a little more nuanced. The UK has tremendous debts, borne out of its overconsumption (trade deficit) for many years. It is therefore, not outside the real of possibility, that the GBP will face significant devaluation, and perhaps high inflation rates soon. If the rate of inflation post 2017 was to exceed 25% then the real yield on this scheme would be negative. (See here for discussion of sovereign default trajectories and how they relate to inflation.) In short, if the inflation rate per annum (and thus, increase in the basic cost of living) is 26%, then the real yield will be approximately -1%, despite a 25% nominal yield. In other words you are less wealthy at the end of the year despite a 25% yield on that investment!
Far be it from me to question the actuaries and financiers who put this scheme together, but I have to say: the notion of a 25% return for supposedly little work/risk terrifies me. I’ll be looking to protect what little wealth I have before this ISA comes out.