The birth of the ISA: The ISA men cometh

BACK IN January, Patricia Hewitt, the Treasury minister now responsible for the new Individual Savings Account (ISA) told us: "ISAs will encourage people who are not saving to get started and those who are saving only a little to save more."

These are big claims yet to be proven. What cannot be denied is that the introduction of ISAs means that our annual allowances for tax-free investment have been cut by half. For the 1999/2000 tax year, the maximum subscription to an ISA is set at pounds 7,000, and thereafter just pounds 5,000 a year. This is against the previous annual allowance of up to pounds 9,000 into regular and single-company PEPs, and an additional pounds 9,000 into a Tessa across five years.

The tax regime for ISAs is the same as that for PEPs and Tessas: exemption from capital gains tax, freedom from income tax, but with the diminishing benefit of dividend tax credits. These have the effect of "grossing up" dividend income. As of April, this allowance has been cut to an effective rate of 10 per cent and will be abolished altogether from 2004.

Permitted investments in an ISA are far broader than under the old PEP/Tessa regime. PEP rules specify that up to pounds 1,500 of the annual pounds 6,000 allowance for a full PEP can go into "non-qualifying" funds. The rest must go into UK and European Union equities and bonds. ISAs will have up to three components: equity, cash and insurance. Of these, the equity portion will be allowed to hold "any share traded on any recognised stock exchange anywhere in the world".

Jason Hollands of BESt Investment warns: "This will matter little to most account holders because of the costs of buying and selling exotic shares. Given the quite low annual subscription limit, these transaction costs could easily eat up any benefits of such a purchase and effectively add to its investment risk."

Even buying UK shares will be rendered less attractive, according to Mr Hollands. "You have to factor in any settlement costs, plus VAT at 17.5 per cent, and then the plan management charge on top. Buying collective funds will emerge as being a lot less expensive."

This relaxation of the rules allows a far wider choice of asset allocation through collective funds like unit trusts, investment trusts or open- ended investment companies (Oeics). If you want to invest your whole allowance into, say, an emerging markets fund, you are free to do so.

Jane Drew, of Fidelity, the US fund management firm, argues that this is a considerable improvement to the old regime. "Take our international fund which used to be non-qualifying and has risen in value by some 244 per cent since launch in 1990. This mixes UK with US, European and other- sector investment. Funds like this will come into their own under the ISA regime."

Elsewhere, Investec Guiness Flight is preparing to offer 14 funds, including its Global High Income fund - previously not even available as a non-qualifying PEP fund - through an ISA account. This invests in mainly US and European government bonds.

In common with other major PEP providers, both Investec and Fidelity will be offering their new accounts with the same initial and management charges that are attached to their PEPs. They will also offer the ISA cash component alongside this.

An important difference is that ISAs can hold a far wider range of fixed- interest securities such as UK and foreign corporate and government bonds. With the exception of UK gilts, all of these must have five years or more until maturity when bought into the ISA, but can be sold out of it at any time. Any gain on such a disposal will stay "inside" the account free of tax. Gilts, National Savings certificates and cash deposits with less than five years to maturity can be held in an ISA over the shorter term.

Meanwhile, only three insurance companies - Norwich Union, Pearl, and CIS - have definitely said they will be offering insurance ISAs. Norwich Union is marketing its own scheme as a mortgage repayment vehicle. The insurance element of this will be a with- profits savings plan, run in parallel with a "non-ISA" mortgage protection policy, combining life, accident, sickness and unemployment cover.

Commission payable to independent financial advisers on the product will be 4 per cent of annual premiums, generally regarded as a low amount, and not surprisingly Norwich Union says it will be marketing the product directly to the public. However, other insurers, including Standard Life, say they have no plans to follow suit.

One very distinctive feature of ISAs is their use of CATmarks. The aim of these is to ensure a "fair and reasonable deal". Applied to the cash and insurance elements of ISAs, they will indicate low minimum premiums, few penalties, and surrender values reflecting the value of underlying assets in an account.

But when applied to the equity element, Mr Hollands thinks there is a real danger that CATmarks will work in favour of UK index tracker funds. "For the first time I can remember," he warns, "the regulations set down by the Government tend to endorse a particular type of fund. This is fine, as long as nobody forgets indexes fall as well as rise."

`The Independent' has produced a free `Guide to PEPs and ISAs'. The 28-page guide, by Nic Cicutti, our personal finance editor, discusses if PEP or ISA investments suit your needs, how to differentiate between them, what the tax benefits are and what their rules are. If you are thinking of taking out a new ISA, this guide, sponsored by Scottish Widows Fund Management, is for you. Call 0345 678910