Isas were created in 1999 to replace personal equity plans and tax-exempt special savings accounts.
The Pep was launched by the Conservative Government in 1986 as a tax-efficient way of investing in equities and then, in 1990, the Tessa was introduced to give people a tax-efficient option for saving cash in deposit-type accounts.
In 1999, the Labour Government decided to scrap Peps and Tessas and introduce its own version of tax-exempt saving in the form of the Isa, in a bid to broaden their appeal and encourage a wider range of investors to take up the products.
Chelsea Financial Services managing director Darius McDermott does not think the early Isas were much of an improvement on Tessas and Peps. “I can only think of one restriction which was removed when Isas came in and that was the geographical restriction. It allowed you to place it in a global portfolio whereas previously 75 per cent had to be placed in the UK or Europe and 25 per cent in emerging markets.”
The early Isa regime was quite complicated and the annual allowance was lower than that available using a combination of a Tessa and Pep. The overall limit was £7,000 but investors could choose between spreading this allowance between mini Isas, equities, insured funds or holding cash or using one maxi Isa.
The insurance Isas allowed people to invest in life insurance funds such as with-profits but these were later scrapped as they proved to be unpopular but otherwise the basic structure of the Isa remained unchanged until April 2008 when the maxi and mini distinctions were scrapped and the maximum investment was raised to £7,200 a year. This can all be put into stocks and shares or half can be put in a cash Isa.
A much more significant change was the scrapping of the tax dividend credit in April 2004. Under advance corporation tax rules, managers of pension schemes and other tax-sheltered investments had been able to reclaim a 20 per cent tax credit on share dividends. When advance corporation tax was abolished, the tax dividend credit was also abolished, although fund managers were allowed to reclaim the tax credit at 10 per cent until 2004.
Figures from the Investment Management Association show that sales of Isas sharply dropped off after this change. Sales of Isas had been dropping steadily from the peak of £8.5bn invested in their first year but 2004 saw the first year of net redemptions from Isas. That year saw net sales of -£874.9m and they have been in negative territory ever since and 2008, perhaps unsurprisingly, saw the biggest outflow of funds in their 10 year history, with £1.5bn being withdrawn.
Fidelity UK retail managing director Gary Shaughnessy says scrapping the tax dividend credit meant Isas went from being perceived as tax-free to being perceived as tax-efficient, which has reduced their take-up.
Shaughnessy says: “The numbers we have done show that in the period since they took away the tax credit, you could have boosted returns by about 13 per cent, which is not a small amount in terms of individual savers’ returns.
“In terms of impact on the Chancellor, we are talking about a figure probably south of £200m which is a big number but, given the various bailouts and the amount of money that has been pumped into the economy in recent months, £200m actually is a relatively low figure with which to give savers some relief.”
Shaughnessy believes reinstating the dividend tax credit would encourage more people into Isas and he is not alone in calling for a revamp of Isa rules. The IMA is calling on the Government to increase the annual allowance to at least £9,600.
Hargreaves Lansdown senior investment analyst Ben Yearsley says despite the removal of the tax credit, Isas have been a success but agrees that the product has had its issues.
“A lot of money has gone in. We are talking billions and billions of pounds but certain actions have not helped it – not increasing the limit, for example. The Government needs to increase the limit to keep pace with earnings and inflation.”
As for the future of Isas, Shaughnessy says they will continue to have a place, particularly at present, as people are trying to make their money work as hard the as possible.
He says: “They will definitely have a place, I have no doubt of that. I just think they could have a much bigger place and be much more effective if we managed to simplify them and make sure they were seen as simple and valuable for all types of investors – both basic-rate and higher-rate taxpayers.”
McDermott believes a more radical approach is needed to boost future Isa sales and says the Government should raise the limit to £10,000 for equities and £3,500 for cash and should bring back the dividend tax credit.
But he is not hopeful of this happening in this year’s Budget: “I see nothing to suggest that they will make a meaningful change.”