How to invest in your kids’ future
You only have to look round the average park to see the lengths parents will go to in order to protect their kids, from mums padding their offspring up like American football players, to those practising ‘helicopter parenting’, where they hover over them, watching every move for hidden dangers.
However, safeguarding your children’s future is about more than day-to-day protection. Somehow parents also need to keep an eye on the future, and build a financial safety net for their kids as they move into adulthood.
An important step in this long-term protection for many children is opening the right child trust fund (CTF) for them. But with many CTFs facing losses – some of them alarmingly large – the question of which CTF is right for you has never been more important, or more difficult, to answer.
What are they?
CTFs are tax-free investment vehicles, available for children born on or after 1 September 2002, introduced by the government to encourage saving for kids. You receive a £250 voucher after the birth of your child (or up to £500 if you qualify for the full child tax credit).
You also get a further payment on their seventh birthday (again £500 if you still qualify for the full child tax credit). The money must be invested in a CTF, which can be accessed by the child when they turn 18.
Where to invest is a troubling decision for a lot of parents. You have a choice between three types of CTF.
1. First is the cash CTF – of which there are several on the market. These are essentially tax-efficient bank accounts with no access until your child is 18.
2. The second alternative is to put the money in a stakeholder CTF, which is invested in the stockmarket but follows certain rules designed to make it less risky.
So, for example, investments have to be spread over a number of companies, and once the child reaches the age of 13 the money will gradually be moved to lower-risk investments, such as cash. The charges are also limited to a maximum of 1.5% a year. In practice, this means that a lot of stakeholders tend to be tracker funds that mirror the performance of the market.
3. The third option is a non-stakeholder shares-based investment. Some of these can be no more risky than a stakeholder, but others are much more volatile investments.
Which one is right for your child?
In the four years since they were launched, the different types of CTF have produced vastly different returns. While some have risen in value, others are now worth only a fraction of the original voucher amount. The value of the average cash CTF, for example, has risen 24.2% to £310.50 over this period, while the average stakeholder CTF is down 7% to £232.50, according to a survey by Moneyfacts.
So does this prove that cash CTFs are the best option for everyone? Not necessarily, says Michelle Slade, spokesperson at Moneyfacts. Cash can certainly be a safe haven during periods of market volatility, but questions remain over its longer-term suitability.
“Although equity-based CTFs have been hit by falling stockmarket values, these accounts are long-term investments, and by the time they mature, equity-based products are likely to have outperformed cash-based alternatives,” she says.
When stockmarkets are soaring, equity-based investments are certainly the place to be, as illustrated in 2005/2006, when the average stakeholder CTF grew 24.2%. The average cash CTF increased by a relatively modest 5.2% over the same period. And, of course, returns on cash are likely to be less impressive this year as interest rates have fallen dramatically. In fact, the average cash CTF rate fell from 6% last October to just over 2% in early May, according to website moneynet.co.uk.
Judging the right fund on the basis of short-term performance is therefore fairly futile. Instead, the correct choice of CTF should be based on your attitude to risk. Cash CTFs are the safest of the three options, which makes them suitable for you if you’re extremely risk-averse. Returns depend purely on the interest rate, and accounts can be opened with a recognised high-street name – which is often reassuring for investors.
However, you’re unlikely to earn as much going down this route as you would with a fund that has stockmarket exposure. The effect of inflation also means that the money in your child’s account may well lose value over time.
Stakeholder accounts are much more risky, as they invest in shares. However, they have risk-mitigation built into the rules, so should be lower risk than some other shares-based investments.
The non-stakeholder shares-based accounts are harder to pin down in terms of risk, because the choice is so wide. Some are highly diversified conservative growth funds, which have a similar risk profile to a stakeholder. Others are riskier.
With a wider choice of investments, there is the potential for enjoying higher returns than those generated by either cash-based accounts or stakeholder products. However, you will be more at the mercy of stockmarkets. A sudden slump just before your child is allowed to get their hands on the fund, for example, could wipe out a major chunk of the gains that have been built up.
The most recently published data on the type of accounts opened since the start of the scheme – the year ended 5 April 2008 – show that 75% of the 3,421,000 accounts are stakeholders, 19% are cash, and the remaining 6% are non-stakeholder investments.
Whichever option you pick, it’s vital that you actually make a decision. Every day that you don’t invest, you miss out on a day of growth. If you don’t invest at all, or take more than a year to make up your mind, the government will put the £250 voucher into a stakeholder CTF, chosen at random. This may not be a fund that has been delivering performance, or one that suits your level of risk, so it’s vital to make the decision early.
Unfortunately, too many parents are failing to do so. In fact, of the 797,000 vouchers issued during 2008, only 54% have so far been invested, according to figures published by HM Revenue & Customs in March this year.
The good news is that your initial decision is not set in stone, because you are allowed to switch between accounts. This is pretty straightforward if you want to switch between the funds of one provider. If you want to switch between providers, you need to sign up with the new company, which will sort out the transfer.
Once the initial £250 is invested, the next decision is whether or not it’s worth friends and family investing up to a further £1,200 a year in the CTF, which is the maximum you can put in each year. Anyone can contribute, and neither the parents nor the child concerned will have to pay tax on any gains or interest.
The gains can be impressive. Investing £30 a month into a cash-based CTF paying 3% for the full 18 years (a total of £6,480) will produce a nest egg of £9,337, while a rate of 5% would provide £11,430. The investment of £100 a month at the same rates, meanwhile, would give you £29,323 or £35,696, respectively.
Alternatives to CTFs
But is putting all your money in a CTF really sensible? While they offer attractive tax breaks, it might also be worth spreading your money between different products. This has a number of advantages. Firstly, in the wider market there’s more choice.
Ben Yearsley, investment research manager at Hargreaves Lansdown, says: “It’s fine to take your free money and put it into a CTF, but most of them are not great quality. I wouldn’t rush to pay any additional money into a CTF and would look instead at a straightforward unit trust.”
Secondly, spreading the money between funds or financial institutions will help insulate your investment from unforeseen shocks.
And thirdly, the child will have access to the CTF the moment they hit 18, regardless of whether they are responsible enough to handle it, so you may want to invest some funds elsewhere, where you can have more control.
The options here are the same as for parents with children born before 1 September 2002 who aren’t entitled to a CTF.
Geoff Penrice, a financial adviser at Bates Investment Services, says this breaks down roughly into high-street bank accounts, the National Savings & Investments (NS&I) Children’s Bonus Bond, and traditional stockmarket investments.
You can even open an individual savings account, enjoy the tax benefits yourself, and then hand it over to your offspring at a later date.
When choosing a vehicle, Penrice says, “parents need to consider factors such as the timescales involved, attitude to risk and tax considerations. For example, bank accounts might be suitable for those who are very risk-averse and want greater access to their money.”
The tax position for each is a little different. NS&I has specific tax breaks, whereas money in the bank isn’t taxed until the child earns more than £100 a year in interest (which tends to mean it’s tax-free). Above this level, money given by parents will be taxed as the parents’ own savings, whereas that given by other relatives and friends will continue to be taxable as the child’s money.
Unit and investment trusts, meanwhile, can be held in a bare trust. Penrice explains: “The tax will be chargeable to the beneficiary, and as children are generally non-taxpayers, the proceeds will effectively be tax-free – other than the 10% withholding tax on dividends that can’t be reclaimed.”
Whatever option you choose, regular saving is crucial to help improve the chances of your youngsters enjoying financial freedom in the years to come. A monthly deposit of £50 could provide the cash to finance university studies, for example, or help with a deposit for a first home. It is one of the most important decisions you can make.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Child tax credit
A scheme started in 2003 that sought to replace a raft of other tax credits and benefits, the payout depends on the number of dependant children in a family, and its level of income. The amount of credit is reduced as income increases. It is payable to the main carer of a child, usually the mother, and is available whether or not the recipient is working.