Money: Tax-Free Savings - Pop goes the PEP bonanza

As things stand, an estimated 750,000 people will have to reduce their tax-free investments

INDIVIDUAL savings accounts will replace both the tax-exempt special savings account (Tessa) and the personal equity plan (PEP) after April 1999, and limit the amount of tax-free investment that can be carried across to an ISA to pounds 50,000. As things stand, an estimated 450,000 people will have to reduce their tax-free investments and many more who are within reach of the threshold may decide it is not now worth investing up to or over the limit.

PEPs have been hugely successful. More than 3 million people have funds invested in them. A PEP allows you to shelter investments from the demands of income tax on any dividends you get from shares and the capital gains tax that would normally be charged on growing investments. You can hold a range of investments inside a PEP, from individual company shares to pooled investments, such as unit trusts and investment trusts, through to fixed-interest investments.

The riskiest PEP-able investment is to buy shares in an individual company. The price of any equity can rise and fall on a minute-to-minute basis. However, if you hold shares, say through a building society flotation, it may be worth putting them in a PEP to save paying tax on dividend income. You can invest up to pounds 3,000 in a single-company PEP each year. If you have any windfall shares in that company they can also be put in a single- company PEP as if they had no value, but you can only have one single- company PEP per year.

The predominant investment vehicle for PEPs are unit trusts. They reduce the investment risk by spreading your money over a wide number of shares. Of the estimated pounds 35bn currently invested through PEPs, around pounds 25bn is in unit trusts.

According to the Association of Unit Trusts and Investment Funds, around half of the near 2,000 unit trusts in existence are PEP-able. Unlike the proposed ISA rules, which will admit any unit trust or investment trust in an ISA, PEP rules require the trusts to be at least 50 per cent invested in shares from the UK or the European Union for the maximum pounds 6,000 per person to be invested. For funds with more than half their investments outside the European Union, the limit is pounds 1,500.

There are a wide variety of unit trusts offering different levels of risk. Those investing in smaller companies have shown some of the best longer-term performance but are high-risk funds. Picking the right fund management house is important, according to Don Clark, of PEP Direct, the independent financial advisers. "I'd be looking to one of the consistent top performers, such as Perpetual, Schroders, Fidelity or Mercury," he says. "The advantage of these companies is that they are big, have large research teams and a wide range of funds, as well as good performance. Their size and range of funds means you won't normally need to look elsewhere at other groups if you want to widen or change your portfolio."

Looking at the charges of PEP managers is important as they can eat into your overall returns. But it is also worth looking beyond the specialist funds to the index-trackers. These are offered by the likes of Virgin Direct, Marks & Spencer, Legal & General and Norwich Union. They have price and simplicity on their side as tracker funds involve no active investment management.

Their aim is simply to replicate the performance of the FT-SE 100, or whichever index they follow. But by their nature, tracker funds can limit the potential return as everyone wants to outperform an index.

The plans for an ISA allow an eight-week consultation period, which may ease the transition. With so much uncertainty, potential PEP investors may be forgiven for fighting shy at present.