Premium bonds lose their lustre

In the past, there were several good reasons for buying premium bonds – lottery bonds issued by the UK government. However, those reasons are fast diminishing as the government instead focuses on persuading individuals to save and invest.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
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Do you have premium bonds? Are you thinking of buying some? Has a family member suggested they may gift you some? Then read on, because premium bonds are not a smart investment idea and the tax benefits of the past have lost their sheen.

Premium bonds were launched by Prime Minister Harold Macmillan in 1956. They proved popular, predating the National Lottery by decades.For the investor, a potential prize of up to £1 million from a monthly draw may seem attractive, although the odds of winning this top prize stand at over 34 billion to 1. Even the odds of winning £25 for every £1 of bonds held stands at 30,000 to 1.

Still, at the last count, 22 million people in the UK had around £68 billion invested in this savings product. A pot of around £66 million is divvied up each month as prizes via a lottery system named Ernie (Electronic Random Number Indicator Equipment).

The interest rate you are unlikely to receive

Premium bonds are quoted to have an ‘average’ interest rate of 1.15%, but in reality this is the ‘mean’ average and very misleading. If you lined up everyone who owned £1,000 worth of premium bonds, the person at the halfway point (the median) would have won nothing over the year. If you ventured further along this line of people you would only meet the first £25 winner, the lowest prize possible, at around the two-thirds mark!

Martin Lewis of MoneySavingExpert.com, along with a team of statisticians, have created a calculator to estimate your probability of winning based on the amount of bonds you hold.1 The maths behind this tool is incredibly complex but demonstrates the lacklustre probability of actually receiving the advertised 1.15% average annual return.

Naturally, if you hold a larger number of bonds you have a higher chance of winning. However, even amongst those with £5,000 invested in premium bonds, only 60% of people are likely to receive £50 or more during the year to at least get close to the 1.15% ‘average’ interest rate. 26.5% of people are expected to win just £25 over the year and 13.5% of people end up with nothing.

Statistically, then, around 40% of people receive significantly less than the published 1.15% rate. This is not a good statistic if you are investing in premium bonds in an attempt to grow your wealth over the long term.

Tax-free interest? No longer relevant

The prizes paid by premium bonds are tax-free and this used to be a key incentive. However, for 95% of the population this perk is now meaningless due to the personal savings allowance (PSA) launched on 6 April 2016.2

The PSA means that you only pay tax on savings interest if you are:

  1. A basic rate taxpayer (20%) and earn more than £1,000 interest a year
  2. A higher rate taxpayer (40%) and earn more than £500 interest a year
  3. An additional rate taxpayer (45%)

The average UK savings account interest rate in 2017 to-date has been 0.91%.3 If you are a higher rate taxpayer you would require savings amounting to £55,000 before you start to pay tax.

What are the alternatives?

If you do not want to take a gamble on receiving such meagre expected rates of return, you can achieve these with confidence by putting your money into a savings account or a cash ISA.

We have written extensively why you should not leave cash in the bank over the long term, mainly due to the rate of inflation currently exceeding the average interest rate on savings account.4 In this scenario your wealth will be continuously falling in real terms

There are many alternatives to holding cash. In a Stocks and Shares ISA you can buy shares, government bonds, corporate bonds, commodities and more. If you feel that you are confident enough to create a portfolio on your own, you can do this in our Share dealing account, be it in a regular account or in an ISA wrapper.

Alternatively, you could choose to invest in a ready-made portfolio that is actively managed by an industry expert. IG recently launched our series of Smart Portfolios. These are based on portfolios put together by BlackRock, the largest asset manager in the world.

When you open your account, we will ask you a series of questions to find the portfolio that best fits your risk profile. The total cost of owning one of these portfolios is significantly cheaper than the average independent financial advisor which studies have shown has a big impact on long-run performance.

 

1 http://www.moneysavingexpert.com/savings/premium-bonds-calculator

2 https://www.gov.uk/government/publications/personal-savings-allowance-factsheet/personal-savings-allowance

3 http://www.swanlowpark.co.uk/savingsinterestdata.jsp

4 At time of writing, RPI April-17 = 3.5%. The best Easy-Access Cash ISA is 1.05% with Virgin Money as of 02/06/17.

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