The extra Pep

Peps may represent the best middle- and long-term investment. Tony Lyons advises on how to choose them

Personal equity plans (Peps) have been a pounds 22bn success story since they were launched by Nigel Lawson in his 1986 budget. If you wish to save for five years or more, Peps will almost certainly be the most tax-efficient investment. Most Peps invest in the stock market, offering an opportunity for your money to earn much more than in a savings account.

The rules are simple. You can invest pounds 6,000 in any tax year (as a lump sum or monthly instalments) in a general Pep - one which invests in several different companies. You can also invest a further pounds 3,000 a year in a Pep which holds shares in just one company. Everyone has an individual Pep allowance, so a married couple can each invest the maximum.

The only exception is that if the money is put into shares or units which are invested outside Europe, the maximum that can be invested is pounds 1,500 per person.

Dividends from shares held in a Pep are free of income tax and you do not have to pay capital gains tax when shares are sold - providing they have been held for more than a year.

The market is dominated by the high street banks, which each have over pounds 1bn in Peps, but they are also marketed by established fund managers, insurance companies and newcomers to the personal finance industry.

Charges have become fiercely competitive. The initial charge for setting up a plan varies from nil to 5 per cent. Annual management charges are usually between 0.7 and 1.5 per cent. All Peps levy dealing charges for buying and selling shares, and all incur stamp duty of 0.5 per cent for share purchases. Some managers also impose exit charges if the plan is cashed within 5 years.

Basically there are four different types of Peps available:

Single-company Peps are for those who want to invest up to pounds 3,000 a year in an individual company. Much of the money invested comes from people who want to share in the future success of the business they work for. Employees can often transfer shares they already own into a single- company Pep free of charge. Otherwise, normal transfer charges are applied.

Self-select Peps are usually offered by stockbrokers and independent financial advisers. The plan manager invests in a selection of funds offered by other management groups, or a basket of qualifying shares and units, for the long term. The manager may offer advice on which stocks to invest in, for which there is usually a charge. If, however, you are a more sophisticated investor and know the ways of the stock market, you can select your own portfolio.

As with all types of Pep, the dividends can either be taken out or, more commonly, reinvested in the portfolio. You can be as active as you want. Just as with any ordinary share investment, stocks can be changed whenever you want, but you will have to pay the dealing costs.

Managed Peps are available from a wide variety of management groups, most commonly unit trust groups and investment trusts. Instead of a selecting a portfolio of shares, investors use their Pep allowance to invest in the chosen fund. Usually, the funds reinvest the tax-free income to buy additional units and so build up the value of the fund.

The most common investment vehicle to date has been UK growth funds. But tracker funds which invest in the stocks which form the FTSE 100 Index are proving increasingly popular, as few funds seem to out-perform the Index in the long term. For a small fee, some plan managers are beginning to offer a guarantee that over 5 years there will be no depreciation in capital even if the underlying investments fall during that time.

Most management groups now offer their Pep plans to people who want to save regularly basis. The main unit and investment trust group usually ask for a minimum investment of between pounds 25 and pounds 50 a month.

Corporate bond Peps - for those who are averse to risk and want an income higher than a building society deposit account - have been available only since last year, and invest in a variety of bonds, preference shares and convertibles that pay a fixed dividend each year, with a lower risk to capital than ordinary shares and units.

Most investors use corporate bonds to supplement income, usually in retirement, and there are now more than 60 different ones on offer. According to the Association of Unit Trust and Investment Trusts, the average corporate bond produced an income of 7.1 per cent tax free over the past year, nearly double a conventional deposit account, and the capital has remained intact