Scrapheap challenge for child trust funds

The first recipients of the UK's children's saving scheme celebrate their seventh birthdays this week and will receive a £250 present from the Government. Free money is not to be scoffed at, but is the child trust fund (CTF) scheme that is supposed to help young people pay for their university fees, training or first home working as it should?

Launched in 2005, CTFs were opened for children born after September 2002, with a £250 voucher, or £500 for lower-income families. This year, the first children to benefit from the scheme have turned seven, prompting the top-up payments, this time paid directly into the fund rather than through a voucher issued to parents. Again, children from families with a lower combined income are in line to receive a £500 payment.

When introduced, CTFs were welcomed by many parenting groups. But the scheme had its critics and their voices seem to be getting louder. "The Government can talk all it likes about helping children get a better start in life, but I'm sure most parents would prefer the money to go into something with a more immediate benefit, like better schools," says Jason Witcombe from independent financial advisers Evolve Financial Planning.

Parents have one year in which to invest their vouchers into one of three fund types – cash, stakeholder or shares-based – which are dependent on the performance of shares and bonds. However, figures from HM Revenue and Customs show that about a quarter of parents forget or choose not to invest the vouchers, leaving the Government to select a default stakeholder fund for them instead.

Many critics of CTFs cite a fundamental flaw in the scheme. "The whole premise under which they were founded is that people like to save in separate pots. The fact is, people don't think that way. They generally have one pot and dip into it as and when they need to," says Peter McGahan from independent financial advice firm Worldwide Financial Planning.

Some parents are also unsure which CTF type is best. The recent stock market turmoil resulted in the average stakeholder losing 26 per cent in the last tax year, while cash CTFs posted growth of 5.1 per cent, according to financial information service Moneyfacts.co.uk.

"The first wave of stakeholder CTFs enjoyed impressive early growth," says Darren Cook from Moneyfacts. "In the tax year 2005-06 the average stakeholder CTF grew by an impressive 24 per cent, but the last two years' performance has deteriorated markedly, reflecting the wider stock market turmoil."

Parents who fail to invest their children's vouchers are also far less likely to make the most of permitted top-ups, which is where the real financial potential lies. Family and friends can contribute a further £1,200 per year into a child's CTF with any interest free from tax. Despite this, many parents are hesitant to put more money into CTFs. Yorkshire Building Society recently disclosed that more than half of parents are choosing instead to put money into other savings accounts for their children. The Children's Mutual, a CTF provider, says that the average monthly direct debit paid into one of its CTFs is £24, which could result in a lump sum of £9,750 after 18 years. Not a shabby return, but it pales in comparison to a potential £36,900 if the maximum additional contributions of £1,200 a year were made.

The reason behind this hesitancy may lie with the uncertainty about how children will spend their money when they turn 18. Most parents hope that their children will be financially responsible enough to use their nest eggs wisely. However, there is nothing in place to prevent them from blowing the entire pot on anything they see fit. One development that may help is that CTFs can now be rolled into an individual savings account (ISA) once it matures but again this is not a requirement.

"By design, it is a disaster. Whenever my child gets to 18, it will be her right to spend it as she likes and we can't do anything about it," says Mr McGahan.

The future of CTFs looks uncertain. The Lib Dems' Vince Cable has already pledged to get rid of CTFs, while the Conservatives have always been lukewarm on the scheme. With government spending to be cut, there may not be many more birthdays for CTFs.