Sounds too good to be true? You are right. This protection comes at a price, and you cannot get rid of all the risks built in to buying shares. However, if you are cautious about the stock market but realise you need a better return than the building society can offer, a protected PEP may be for you.
There are two sorts of protected PEPs: unit trust funds you can buy into at any time in the same way as a general PEP; and "packaged" protected PEPs with a fixed term, usually five or six years.
A general protected PEP will limit the amount of money you can lose every quarter or every year. The fund managers do this by buying options contracts to hedge their risk against stock market movement. Some of these protected PEPs have a normal equity fund, usually an index tracker (see page 19 for more on tracker PEPs) as the main part of the investment. The managers then take out "put options". These are derivatives contracts which give the managers the right to sell the value of the index being tracked (the FT-SE 100) at a fixed price. The contracts usually last for three months, which is why some of these PEPs quote a quarterly "floor" below which your investment cannot sink. The Govett UK Equity Safeguard fund, for example, cannot fall by more than 2 per cent a quarter.
Other funds have annual "floors" - the market leader in this area is the Scottish Widows Safety Plus PEP. It guarantees that your investment can only fall by 5 per cent a year.
The downside to these funds is that you will not get the benefit of a full rise in the stock market. The managers cream off some of the returns in order to make money on the fund and pay for the options contracts.
The second type of protected fund is a "packaged" PEP with a short subscription period and fixed investment term. As we come up to the April PEP deadline there are likely to be several packages launched. There are four on offer at the moment from HSBC, Midland Bank branches, GE Assurance and Scottish Widows (see box).
You have to commit your money for the length of the contract or risk losing it. The managers use the investors' cash to buy a derivative package to mirror the returns on a particular index (almost always the FT-SE 100) over the fixed period. If the index goes up over the period, investors get their money back, plus growth up to a stated limit.
"There are no charges for the money you pay in," says Victoria Lee at HSBC. "The charges are wrapped up in what you get back."
The limit on the upside of these funds is that the investor is no better off whether the FT-SE 100 rises by 1 per cent or 100 per cent over five years. Despite this, these packaged funds have taken in billions of pounds. These PEPs qualify for a pounds 9,000 PEP allowance, taking in the pounds 6,000 general allowance, plus the pounds 3,000 single company limit. If you are interested in buying a protected fund, but are not convinced you will be able to leave the money untouched for five or six years, then the permanent types of protected PEP may be a better bet.
Ian Milward at IFA Chase de Vere says: "We use the packaged PEPs more for investors who want a low-risk fund as an alternative to a deposit account. The other type of fund is more dependent on the fund manager's ability, and they run the risk of disappointing investors if they get things wrong."
Contacts: Govett, 0845 300 9090; Scottish Widows, 0345 678910.
Current protected PEP offers
GE Financial Fund Management, 0181-380 3000.
GE Financial is an unfamiliar name but it is owned by the US utilities giant, General Electric. Its GE Capital Premier Fund pays 7.5 per cent a year for five years or the income can be left to grow with a guaranteed return of 42 per cent after five years.
Investors get all their original capital back at the end of the term if the FT-SE 100 remains the same level or has risen. Any fall means that percentage of original capital is lost - a 10 per cent fall means a 10 per cent loss of capital.
The HSBC Capital Protected Income PEP, 0800 289 505.
Aims to pay 7.25 per cent income per year for five years but this may vary depending on interest rates and stock market movements. Investors who stay in for the full term get their original investment back, regardless of stock market performance.
Midland Capital Protected Growth PEP, 0800 299 299/or Midland-HSBC branches.
Six-year investment linked to growth in the FT-SE Eurotop 100, an index of the largest European companies. Return of capital guaranteed plus all growth in the index up to a maximum of 70 per cent.
The Scottish Widows Extra Income and Growth PEP fund, 0345 678910.
Offers an eye-catching fixed annual rate of return of 8 per cent for five years on a minimum investment of pounds 3,000.
The higher rate comes with some extra risk: original capital is only returned if the FT-SE 100 rises over the five years. If the closing index price is 5 per cent below the level it was at the start, investors will only get back 95 per cent of their capital.