Secrets Of Success: Some of the child trust funds must end in tears

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The Independent Online

One of the glories of the political system we have in this country is the quite inordinate amount of time and trouble it seems to take to implement even the simplest of ideas. The Treasury's Child Trust Fund plan, which in essence is about as simple as you could imagine, and not even a bad one either, appears to be a wonderful case in point.

The first children to receive the benefits of their Government-funded trust fund will do so in April, 2005, it was announced this week, though those born between 1 September, 2002 and the starting date will still qualify for a starting payment, suitably adjusted, retrospectively. (Surely this needless complication has nothing to do with the political benefits of spreading the potential beneficiaries as widely as possible before the next election, and to hell with the administrative consequences?). The basic idea of the scheme is that every child whose parents qualify for child benefit will be given between £250 and £500 to invest in a fund which will mature when they reach 18.

Parents and relatives will be able to chip in up to a further £1,200 a year to top up the Government's initial contribution, and they will be able to choose where to invest it.

Though it is undoubtedly gimmicky, there is nothing wrong with the trust fund idea, as far as I can see. The thrust behind it is that it will help children (and their parents) to learn to appreciate the value of saving for the long term, which is an unexceptionable ambition, and at the same time provide young people with a lump sum they can use when they are 18.

Even an initial payment of £250, which will be topped up at the age of seven by a second payment, probably of the same size, could well grow into a reasonably valuable lump sum by the time it matures, especially if it is fed by family and friends, as the Government hopes.

The question of whether the average 18-year-old will actually do anything useful with the money (or be allowed to do so by their parents) is another matter. If nothing else, so the cynics have already pointed out, it may help would-be university students offset part of the cost of their postgraduate education, but there will inevitably be many cases where the cash ends up in a less deserving cause.

There are 700,000 children born each year, so the scheme will cost the taxpayer about £175m a year, assuming every child does qualify for the minimum payment of £250.

Children from lower-income families below the tax credit threshold will be given a larger initial sum, up to a maximum of £500, so the final cost will be somewhat higher. It is impossible to know what returns those who qualify for the initial payment will make over the 18-year life of their fund.

On the basis that the stock market is no longer wildly, but merely mildly, overvalued, conventional wisdom suggests a central case outcome for a mixed bond-equity fund might be a compound annual return of say 5 to 7 per cent over the life of the fund. That assumes inflation stays at its present level. But I do foresee some interesting pitfalls for the trust fund idea. One is that the actual range of outcomes will be very wide, and almost certainly much wider than the Government is bargaining for. This is not just because the returns achieved by different children will be affected by the kind of asset mix they (or rather their parents) plump for at the outset.

And linking the timing of the initial and secondary Government payments to a child's date of birth and seventh birthday also introduces a high degree of randomness into the process. Fixing what is essentially an arbitrary start and end date for the life of the fund will inevitably mean the value of the trust fund becomes something of a lottery.

The difference in the value of a fund that achieves a return of, say, 2 per cent per annum and 12 per cent per annum, compounded over 18 years, will be more than a tenfold difference in the final lump sum. Political life being what it is, you can be certain that in years to come there will be complaints about the inequality of the outcomes.

A further factor is that those who qualify for the extra payment because their families are poor at the outset will not necessarily still be among the poorest groups 18 years later.

Another interesting question to be answered is whether those supervising the trust fund will be able to make adjustments in the asset mix to reflect changing market conditions. Logically, they should be able to; if you can switch your pension fund or savings fund, why not the same with your child trust fund?

But that will also materially affect the range of final outcomes, with potentially interesting consequences.

The underlying reason for this is that investment returns are not consistent over time, except in the very long term. As the economist Andrew Smithers has pointed out, when you decide to put your money into the markets makes a big difference to how well you do, as does the length of time you have to hold that investment.

While most people comfortably assume shares are the best bet for anything over about a 10-year time horizon, his work demonstrates that, in fact, you need to be invested for nearer 30 years than 10 years to have a high degree of confidence that the equity market will provide the superior return it is expected to provide.

One obvious answer would be to make sure the trust fund payments from the Government are made on a regular savings scheme basis rather than as lump sums. That way you would eliminate a good deal of the date-specific randomness introduced into the process, though the issue of inter-year differential returns will still remain.

What does not seem to me in doubt is that the Law of Unintended Consequences will eventually come into play. The irony is that the effect of randomness will certainly have a big, and possibly perverse, impact on the Government's pious intentions of reducing rather than increasing inequalities of accumulated wealth with this patently well-intentioned scheme.

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