The race is on

PEPS AND TESSAS The investment institutions are scrambling to tempt savers with a bewildering array of tax-free
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WITH only six weeks to go until the end of the tax year and millions of savers holding maturing tax-exempt special savings accounts, banks, building societies and investment companies have entered a frenzied competition to attract your money.

They are all determined to persuade you that their personal equity plans (PEPs) or tax-exempt special savings accounts (Tessas) are the best way to earn tax-free capital growth and income. Many offer special incentives or discounts to give their products extra bite.

But rather than making it simpler to choose where to put your money, the process has become even more confusing. For example, do you go for a PEP with a special reduction on its initial charges until 5 April, or a Tessa which guarantees an extra 0.25 per cent above the average top 10 building society rate throughout its life?

Martin Mullany, a director of independent financial adviser Brooks Macdonald Gayer, says that, ideally, you would take out both a Tessa and a PEP: "It's a good idea to protect as much of your money as you can from income and capital gains tax. But before you decide, you need to make sure you know what each type of investment entails and whether it meets your needs."

Investors who want to develop a balanced portfolio should split their money between three types of investment: cash deposits, fixed- interest securities and shares. The cash deposit provides security and makes it relatively easy to get your hands on the money. The fixed-interest securities provide income at a moderate level of risk. The shares offer income and capital growth but carry greater risks. By investing in both Tessas and PEPs, your portfolio will have all these attributes.

PEPs were introduced by Nigel Lawson in 1987 during his tenure as Chancellor. He hoped to encourage private individuals to buy shares in UK companies by providing them with a limited tax shelter for those investments.

At first, you could only invest a maximum of pounds 2,400 each tax year (6 April to 5 April the following year), and just pounds 420 of this allowance could be placed in a unit or investment trust. This structure was unpopular, proving too small for large investors and too risky for small investors.

The allowances for PEP investment have since been extended, and there are now more than 200 companies offering more than 1,000 versions of the PEP. You can now invest pounds 6,000 each year in a general PEP, selecting your own portfolio of shares or using all your allowance to protect unit and investment trusts from tax. The principal investments that can be sheltered in a PEP are:

q Corporate bonds. These are IOUs issued by companies that want to raise extra capital. The business issuing the bond promises to pay a fixed rate of interest at regular intervals and to redeem the bond on a predetermined date at a fixed price. You can buy these bonds individually or in unit trust form. Purchasing through a unit trust gives you a spread of IOUs and therefore less risk, as well as professional management of that portfolio. These bonds give a regular income of about 7 to 8.5 per cent.

q Unit trusts. These are funds that pool investors' money to buy a much wider range of shares or bonds than they could normally afford. As the money is spread across a broader portfolio, your prospects do not depend on the fortunes of any one company and the risk is diluted. The trusts are divided into equally-sized units which rise and fall in value in line with the performance of the investments owned by the trust. Some are designed to produce income by investing in high-yielding shares or bonds, while others are designed to give capital growth.

q Investment trusts. These funds also pool investors' money and so reduce risk. However, unlike unit trusts, they are divided into shares which can be bought and sold on the stock market. The value of the shares rises and falls in line with demand, quite separately from the performance of the investment held by the trust. These funds are more complicated, and can be more risky, than unit trusts

q Shares. If you want to hold shares directly in a PEP, you must stick to companies listed on the UK and European Union stock markets.

You can use your full pounds 6,000 allowance to invest in "qualifying" unit and investment trusts which have more than 50 per cent of their money in the UK and EU stock markets.

Only pounds 1,500 can be invested in "non-qualifying" trusts, which have less than 50 per cent of their holdings in the UK and EU.

PEPs based on a portfolio of corporate bonds, or unit and investment trusts, generally entail a medium level of risk. They are suitable for investors who are prepared to lose some of their money in return for the opportunity of higher levels of growth or income. PEPs that hold a limited number of company shares are much more risky. Single company PEPs, which allow the investor to buy up to pounds 3,000 worth of just one business's shares, are the most risky of all.

If you are the kind of person who wakes up sweating in the middle of the night because your BT shares have fallen a penny, these are not the right investments for you.

Nervous investors are probably better off sticking to the lower, but more reliable, returns provided by a Tessa. Up to pounds 9,000 can be invested in a Tessa over five years, and any interest earned on the account is completely tax-free provided the capital is untouched for five years.

If you are desperate for money in the meantime, you can draw out the taxed interest. But if it becomes necessary to dip into the original capital or the tax-free part of the interest, the whole account must be closed and tax paid on any profits.

However, this may still prove more profitable than investing in a taxed deposit account. Mr Mullany says: "Even when it is taxed, the interest paid on Tessas is usually higher than that paid on normal building society accounts."

The potential returns on a Tessa are much lower than those that can be obtained by investing in a personal equity plan. But the Tessa has one great advantage over a PEP - you are guaranteed to get your original capital back.

Building societies and banks have increased the certainties of Tessas by offering accounts which pay a fixed amount of interest over the five- year term. Those investors who opened fixed accounts five years ago have fared much better with these: some have provided returns of more than pounds 14,000 compared with the average Tessa payout of pounds 12,000.

But Fiona Price, of the independent financial adviser Fiona Price & Partners, is dubious about the attractions of fixed rates now.

She said: "This Government is committed to low inflation and low interest rates, but if Labour wins the next general election, the situation could change. I'd certainly think carefully about locking into a fixed rate."