Child Trust Funds are now three years old. The current economic climate - a faltering housing market, global stockmarket jitters and potential recession not only in the US but also on these shores - means saving for the future has never been so important.

Since the scheme was first launched in 2005, 3.7 million government vouchers have been sent out to parents. Of these, 2.6 million have been invested by parents into a cash, stakeholder or stocks and shares CTF. The remainder are either still outstanding or have been put into a stakeholder scheme automatically by the government.

The idea behind CTFs is simple – by handing over free money to all babies born after September 2002 and offering them a tax-free investment or savings vehicle to keep the cash until they turn 18, the government hopes to encourage the savings habit and give young people a financial opportunity for when they turn 18.

While, in theory, CTFs should encourage saving, not all parents are taking advantage of the benefits they offer. And where they invest the money can make all the difference to their children when they celebrate their 18th birthday.

The basics

CTFs are a tax-efficient savings and investment account for all children living in the UK born on or after 1 September 2002.

Babies born between 1 September 2002 and 5 April 2005 are eligible for a lump sum of £256 from the government (or £512 if their families qualify for full Child Tax Credit) while those born before after 5 April 2005 have or will receive a voucher for £250 (or £500). Parents are then obliged to invest this money into a CTF. The government will pay children a further cash amount into a child’s CTF when they turn seven.

Although parents, family and friends can make contributions up to £1,200 a year, the money cannot be withdrawn until the child turns 18. However, the money can be moved into a different account at any time and from 16 the child can take control over where his or her nest egg sits.

There are three types of CTFs:

• Stakeholder, where the money is invested in stocks and shares until the child hits 13 when it shifts to a lower risk investments to lock in previous growth. The maximum charge is capped at 1.5%.

• Cash-based savings account with a bank or building society.

• A stocks and shares account, where the money is invested in the stockmarket. The charge can be more than 1.5%.

Cash versus stakeholder?

So what is better; cash, stakeholder or stocks and shares? For some parents, a cash account may seem the safest option because it does not have any element of stockmarket risk. In addition, these accounts are fee-free whereas the majority of stakeholder schemes charge the full 1.5% fee.

Rachel LeBrocq, spokeswoman for the Building Societies Association, said: “People who might choose cash are those who are risk averse or low risk - they do not wish to risk losing any of the capital they have invested. Cash is also an ethical investment so will suit people looking to invest their child’s money ethically.

“The advantage of cash over equity is that you will get back all the money, plus interest, at the end of the 18 years."

However, if you are looking to maximise the returns your child receives when they hit 18, then a stakeholder or stocks and shares options is probably the best bet. A CTF is a long-term investment, and over longer periods of time the stockmarket has tended to produce better returns than savings accounts.

Michelle Slade, analyst at Moneyfacts.co.uk, admits the performance of stockmarket-based CTFs was negative last year, as a result of the general poor health of the stockmarket and ongoing credit crunch. But he adds: “CTF are long-term investments and investment versions are expected to outperform savings versions in the long run.”

And David White, chief executive officer of The Children’s Mutual, said: “We don’t offer cash accounts because these are not likely to maximise the returns for your child. CTF are a long-term investment so if you want to maximise returns then this is the way to go.”

When deciding whether to opt for cash, stakeholder or stocks and shares, the most important thing is to weigh up the pros and cons of each option. LeBrocq adds: “Parents should be able to take a balanced approach to children's savings - balancing equity risk and potentially higher returns, with the certainty of cash-based savings.”

One advantage of CTFs is that you can move the money to a different type of account and age 16 children can start to make decisions about how their money is managed too.

Contributing

Once you have decided where to invest your child’s initial government voucher, the next decision to whether you want to make extra contributions.

White suggests parents try and get the whole family involved in CTF contributions: "Parents should pay in as much as they can afford, but if grandparents, godparents or aunts and uncles want to give some money then why not suggest they do so through the CTF – it will make a difference. Many parents expect to have to help their children out financially as adults, but by making contributions you can spread that cost and generate more money tax-free.”

Figures compiled by The Children’s Mutual reveal the true cost of not contributing to a CTF. It estimates that if you were to put your child’s initial government cheque into a FTSE all share tracker CTF with a projected interest rate of 7% today, then in 18 years time they would be left with just £1,106, taking into account a further government payout of £250 and a 1.5% charge.

The same scenario but with a cash CTF with an interest rate of 4.5% would leave the 18-year-old with £772.

However, if you contributed £50 a month into the FTSE CTF, your child would receive a payout of £19,100 in 18 years time, or just £14,900 in a cash CTF.

When it comes to making contributions, it is worth bearing in mind that some CTF have a minimum contribution. However, all stakeholder CTF providers must accept minimum payment from £10.

Official government figures show 23% of parents contribute to stakeholder CTFs, while just 23% make contributions to cash accounts. In contrast, 48% of parents who invested their child’s money in a stocks and shares CTF scheme make extra contributions.

The lack of contributions is likely to be down, in part, to apathy among parents as well as affordability issues. However, there is also an argument against putting money into a CTF.

For a start, some parents do not like the idea that their child will have free reign over the money as soon as they hit 18. There are no boundaries on what they can spend the money on – meaning a rash teenager could end up blowing their hard earned cash on luxury items such as music and clothes rather than putting it towards further education or a property.

However, as White points out, it would be impossible to limit what teenagers could spend the money on. And figures from The Children’s Mutual could over 50% of 18-year-olds would rather save a lump sum than spend it.

White said: “You’ve got to give credit to teenagers. Their parents were brought up in an environment that was all about borrowing and spending but this generation of young people has realised that saving now and spending later is a better approach.”

Alternatives to Child Trust Funds.

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