Interest in Tessas wanes

Booming markets have led investors to favour shares, says Clifford German

The popularity of Tessas, the brainchild of John Major's solitary Budget as chancellor in 1990, has slumped since the first series started maturing early this year and investors were able to take their money out without losing their tax-free advantages.

Interest rates have halved since the frenetic early days when the first generation Tessas were launched in January 1991.

Out of pounds 30bn worth of Tessas at the end of last year around pounds 20bn has already come up for renewal or withdrawal and, apart from the accumulated tax-free interest, it now looks as if up to a third of the original sums invested have been withdrawn.

There was a net outflow of pounds 6bn in the first quarter, and the net inflow of new money to banks and building society Tessas was just pounds 500m in the second quarter and little more than that in the third quarter.

Almost all the activity that has been taking place has been in maturing Tessas. Even Birmingham Midshires, which offers relatively attractive rates on both variable and fixed-rate Tessas admits that only 6 per cent of its accounts this year are new money, with the balance being old accounts which were renewed as they matured.

In fact, only 20 per cent of active investors favoured Tessas this month, according to a poll of clients by Bristol-based brokers Hargreaves Lansdown, compared with 41 per cent a year ago and a peak of 44 per cent in January and February when the first accounts came up for renewal.

After seeing the interest rates on their first generation Tessas slashed and feeling unable to move the money for fear of losing the tax-free advantages, Tessa investors this year have been much more interested in fixed-rate offers.

According to Abbey National, nine out of 10 customers renewing their Tessas earlier this year were opting for fixed rates this time round. But some providers did appear to be offering special variable rates on roll-overs to persuade existing investors not to take their money away, and there was a widespread worry that whatever happened to interest rates on other savings, Tessa providers would adjust their variable rates downwards as soon as they had locked roll-over customers back in.

These fears seem to have been overdone, at least in the early stages, but investors should be aware of the possibility that they could be taken for a ride if they are too trusting or pick a Tessa solely for its attractive current rate. Although Tessas can be transferred from one provider to another without losing the tax advantages most providers will charge up to six months' interest for an early exit, while some offer loyalty bonuses which are only available if investors stay the course with their first- choice providers. So it is important to know the incentives and penalties as well as the current rate on offer, and even then investors have to take a lot on trust.

Since the new year, base rates have come down by 0.75 per cent, while variable Tessa rates have come down by various amounts. Halifax, the market leader, cut rates in April and again in August and is now offering 5.45 per cent interest which becomes 6.24 per cent inclusive of loyalty bonuses for staying the full five years, compared with 5.9 per cent or 6.49 per cent inclusive of bonuses in January.

Its fixed rate offer is actually now 7.15 per cent including bonus, compared with level 7 per cent in January.

Northern Rock was one of the best early offers on roll-over Tessa accounts, paying a variable rate of 8 per cent on a maximum holding of pounds 9,000 and a fixed rate of 7.64 per cent over the full five years. The fixed-rate offer soon sold out and has not been replaced, while the variable rate on the maximum investment has come down to 6.6 per cent, and the distinction between new and roll-over Tessas has disappeared.

According to MoneyFacts, NatWest and West Bromwich BS offer the best fixed-rates at present, 7.45 per cent on pounds 5,000 and pounds 3,000 respectively, with 180-day penalties for early transfers.

National Counties BS still offers 7.20 per cent variable on a renewed Tessa of pounds 9,000 and charges 90 days' interest on holders who want to take their money away.

Birmingham Midshires, which picks up most of the prizes for the best current offers on amounts as small as pounds 1,000, is still offering a variable interest rate at 7 per cent over the same period - a cut of only 0.25 per cent since the start of the year, but its transfer charge is 180 days loss of interest. Its fixed-rate Tessa remains at 7.05 per cent.

While interest on Tessas has come down, the interest on bank and building society deposit accounts has fallen, and from a lower starting point, so that the amounts now being offered are at 30-year lows in many cases. Yet building societies remain consistently popular in Hargreaves Lansdown's sample. While many investors are well aware of the way in which the interest they earn is unilaterally reduced by the building societies, most are unaware of just how much these rates have been cut, and others are aware of the reductions but feel compelled to sit tight rather than risk losing a windfall bonus when their societies convert to banks.

The best rates can be as much as 4.5 per cent gross on instant access accounts as small as pounds 100, rising to 5.5 per cent on postal accounts of pounds 500 and 6.25 per cent on 90 day accounts of pounds 5,000 or more, but many accounts are now earning 3 per cent or less and, unlike Tessas, interest is taxed at source unless holders register as non-taxpayers.

Straight shares, however, are now the most popular outlet for regular investors, with 44 per cent of this month's sample favouring shares, almost double the proportion this time last year. It is not entirely surprising given the strong showing of the London stock market this year, but shares have even outshone PEPs, unit trusts and investment trusts.

Although PEPs are still a seasonal investment with purchases concentrated in the last few months of each financial year, the emergence of shares as the single most popular investment may mean a significant proportion of active investors may have filled their allocation of PEPs.

Unit trusts are much less seasonal investments than PEPs, there is no limit on individual holdings, and they are still the preferred choice of 17 per cent of the investor sample, much the same as this time last year.

Whether they would have done better but for the adverse publicity generated by Peter Young' manipulation of Morgan Grenfell's European funds is a good question. Investment trusts are now favoured by just 20 per cent of investors, and have been gradually declining relative to unit trusts.