Is the 10-year-old Isa still a hit?

By Kevin Peachey
Personal finance reporter, BBC News

Flat Eric was at number one in the UK when the Isa was brought in

When the tax-free Individual Savings Account (Isa) was launched in April 1999, a head-banging yellow puppet called Flat Eric was starring at the top of the UK singles chart.

The government vowed that it - the Isa, not Flat Eric - would still be around 10 years later.

The prediction has proved to be true.

The Isa is still a key battleground for banks, building societies and even supermarkets trying to attract savers and investors.

Meanwhile, Flat Eric - which featured in the video for "Flat Beat" by French artist Mr Oizo - seems to have fallen in public popularity.

Dream or nightmare

The Isa was promoted as a small investor's dream when then-Chancellor Gordon Brown announced plans for the tax-exempt accounts in 1997.

Isas tend to appeal to people who have spare cash. We still have not cracked the long-term savings problem in the UK which is that we do not like to save Andrew Clare, Cass Business School Q&A: Are my savings safe?

The government wanted the Isa to be a means of encouraging people to save, by allowing them to wrap up stocks, cash and insurance in one account.

At first, there was a £7,000 limit on contributions into an Isa, later to settle down to a £5,000 annual limit - of which £1,000 could be in cash, £1,000 in life insurance, and £3,000 in stocks and shares.

Initially, many potential savers considered the rules too complex. But as the Isa's predecessors - Peps and Tessas - were phased out, the Isa began a long run of popularity.

This was helped when the system was simplified in April 2008. The "maxi" and "mini" Isas were scrapped and the maximum investment in any one tax year was raised to £7,200.

Under the new scheme, all this amount could be saved in a stocks and shares Isa, or half could be put in a cash Isa.

The global financial downturn has put pressure on the government to make Isas more attractive, and so there is a chance that Alistair Darling may tinker with these limits in his Budget next month.

Shares blow

The downturn also featured plunging share prices - a blow for many whose savings in a stocks and shares Isa was affected in the same way as many other investments.

Gordon Brown announced the launch of Isas when he was chancellor

Average returns on new cash Isas have also fallen sharply in recent months. While the account is tax-free and access to funds is relatively easy, the average interest rate has fallen to a record low.

At the end of February the average interest paid on a cash Isa was 0.96%, according to figures from the Bank of England. This compared with 5.06% a year earlier, and was significantly lower than the peak average interest of 6.67% in April 2000.

That said, some of the best-buy instant access cash Isas on offer now have interest rates of about 3.5% - considerably higher than the current Bank rate of 0.5%.

Corporate bond Isas offer better returns - at about 4% or 5% - but the risks are greater.

Cash Isas remain the more popular of the two forms of Isa. Provisional figures from HM Revenue and Customs show that cash Isas make up 65% of the £220bn saved - that is £142bn in cash Isas compared with £78bn in stocks and shares Isas.

There were 14.7 million accounts taken out during 2007-8, up from 9.3 million in 1999-2000. Men still had more of these than woman, although women were taking them out at a faster rate.

Wherever you look

The numbers display an opportunity for banks, building societies and other providers to heavily promote their particular products.

Saving rates may be at an all time low but, the average rate is still higher than that on a current account Brad King, Compareandsave.com

For example, the Halifax - now parts of Lloyds Banking Group, says its research estimates that two-thirds of British savers are not using up all of their entire 2008-09 Isa tax-free allowance.

"The Isa has proved to be a very popular savings vehicle since its introduction, but it is worrying that savers still are not making the most of their allowance," says Flavia Palacios Umana, head of Halifax savings products.

Open any newspaper at present and you will see Isa adverts. The same is true if you look in bank and building society windows.

So why now?

It is simply because savers can only open one Isa each tax year. Banks are encouraging savers to open an Isa or fill up their existing one before the end of tax year on 5 April.

Savers are then free to open another one at the start of the 2009-10 tax year.

But why open an account now when interest rates are at a record low? Some say that the economic and employment uncertainty makes saving even more of a priority.

"In the current economic climate creating a savings buffer provides added security and a reserve for unexpected expenses," says Brad King, managing director of website Compareandsave.com.

"There are also still some decent rates to be had if you shop around for the best deal.

"After all, saving rates may be at an all time low, but the average rate is still higher than that on a current account."

Changing landscape

The government's ambition that Isas encourage people to save has been realised to some extent, according to independent financial adviser Anna Sofat.

Previously, money going into cash Isas tended to be funds that were being previously saved elsewhere, she says.

But the scheme has pushed people to invest in stocks and shares who might not previously have done so.

"It has encouraged some to think in the longer-term, by shifting their cash into stocks and shares," she says.

She said that despite the recent upheaval, some small investors were now considering going back into the markets.

But the cheerleading for Isas is not echoed by everyone.

Andrew Clare, professor of asset management at Cass Business School in London, says the system has simply been "a tax-break for the middle classes".

"These Isas tend to appeal to people who have spare cash. We still have not cracked the long-term savings problem in the UK which is that we do not like to save," he says.

He says that Isas have not helped working class people save and, whatever their effect, they have not altered the basic issue that UK consumers have "over-borrowed" in the last 10 years.

If Flat Eric could talk, he might argue that his hit music crossed the class divide - even if it did not celebrate the same longevity as the Isa.