Undecided? Jump on the escalator

PEPS AND TESSAS Should investors go for fixed rates or variable rates? Chris Wicks looks at the options
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INVESTORS who consider taking out a Tessa face a wide and confusing choice of accounts.

When Tessas were introduced five years ago, most accounts offered variable interest rates, which move up and down in line with the base rate set by the Government. Very few Tessas were fixed, guaranteeing to pay a set amount of interest for a predetermined period.

Now nearly every bank and building society offers its own range of Tessas, including variable-rate, fixed-rate and, in some cases, accounts which are linked to the performance of the UK stock market. The rates on offer depend on how much you can afford to invest and whether you are making a new investment or reinvesting the capital from a previous Tessa.

Large banks and building societies can afford to be more vociferous in advertising their accounts, but investors may find that their small, local building society is offering much better rates of interest.

The little-known Kent Reliance Building Society paid the top variable interest rate on the first round of Tessas, producing a maximum maturity value of pounds 12,400.

Some of the better interest rates are being offered only to investors who reinvest the proceeds of their first Tessa. For example, Allied Trust Bank offers one of the most attractive rates of 7.25 per cent per annum for people who invest the full pounds 9,000 capital from their previous Tessa. This is a variable rate, but if it is maintained for the full five years, investors could expect a return of pounds 12,771 when their Tessas mature.

Five years ago, when interest rates were high, most people plumped for variable-rate accounts that were then paying up to 14 per cent. But as interest rates steadily fell, the few investors who had decided on a fixed- rate Tessa looked increasingly wise.

This time round, fixed rates look much more competitive against their variable-rate cousins, and banks and building societies seem particularly keen to encourage second-time Tessa investors to put their money into fixed-rate accounts.

But before you commit yourself to a fixed rate, you should consider what might happen in the future. Within 18 months the UK will have a general election, and opinion polls indicate that Labour stands a good chance of winning.

Labour governments have, in the past, been associated with higher levels of inflation and interest rates.

While a fixed-rate Tessa will give you certainty of return, you will miss out on any increases in interest rates. At the end of the day, the choice between fixed and variable is a gamble. The right decision for you will depend on your view of interest rates.

One solution may be provided by the new escalator Tessa. This pays a guaranteed rate of interest which increases every year. You can therefore be assured that your return will improve year on year. For example, the Woolwich Building Society Escalator Tessa (available only to existing Woolwich Tessa holders) pays 5.5 per cent in the first year, increasing to 9 per cent in the fifth. An investment of pounds 9,000 in this account would grow to pounds 12,619 after five years. The Allied Trust account offers 6.25 per cent in the first year increasing to 8.75 per cent in the fifth year, boosting a pounds 9,000 investment to pounds 12,739 - an improvement of pounds l20 on the Woolwich Tessa.

You can now also tap into growth in the stock market through a Tessa. The HSBC Tessa Plus account offers a minimum return of 25 per cent of the amount invested when it matures in five years.

In addition, it will provide a bonus of up to 30 per cent based on the growth in the FT-SE 100 index of leading UK shares over the same period.

The index must grow by 55 per cent for the full 30 per cent bonus to be paid. If it achieves less growth than this, a proportionately lower return will be paid to the investor.

The Bristol & West Building Society offers a similar stock market linked account. The society guarantees a minimum return of 20 per cent on maturity but has no ceiling on the growth which can be achieved through the index.

The HSBC and Bristol & West Tessas offer potentially greater returns than conventional Tessas but savers are strongly locked in for the full five years.

If these accounts are encashed early, not only will any interest already credited become taxable, but savers will also face hefty charges.

q Chris Wicks is financial planning manager for the chartered accountancy firm Kidsons Impey Scott Lang.