The UK has a long-standing love affair with premium bonds.
They have been the nation’s most popular savings product for years, thriving on people’s dreams of becoming instant millionaires.
On the surface, this savings account might look appealing. It is easy to understand, offers tax-free prizes, and – issued by the state-backed National Savings & Investment (NS&I) – is a (relatively) safe place to house your money.
But if you dig a little deeper, it’s apparent that we would be better off averting our obsession with premium bonds into other savings vehicles. Here is why.
With one person in 24,500 winning the jackpot, you’re far more likely to become a millionaire by buying premium bonds than by purchasing a ticket for the National Lottery, for example, where the odds amount to one in 45m. Yet, the odds are still stacked heavily against you.
The annual prize rate for premium bonds sits at 1.4 per cent, but that’s not the same as an interest rate – it’s the average return of everyone who participates, including those who win and those who don’t. If you take out the million-pound prizes won by a lucky but very rare few, the return works out at a whole lot less than 1.4 per cent. And if you remove all the smaller prizes as well, that’s a potential return of zero.
According to figures from Moneyfacts, the average interest rate for savings accounts is 0.5 per cent, which is certainly better than the high chance of earning nothing at all.
Safe and sound
Yes, premium bonds offer 100 per cent security for your money, so you won’t lose out directly in terms of the headline figures.
But your cash might not be as safe as you think. Indeed, keeping your savings in premium bonds for long periods of time means you could actually be losing money without realising.
“Premium bonds are a sure way to see the real spending power of your wealth chipped away by inflation over time,” says Tilney’s Jason Hollands, pointing out that the 1.4 per cent annual yield on the total pool of premium bonds is well below inflation at 2.5 per cent.
“True, a 1.4 per cent annual yield is better than some savings accounts, but there is no certainty that an individual will achieve this rate of return. Yes, they have a chance of winning the monthly jackpot, but the odds are tiny.”
“Savers should ask themselves whether they are they in a situation where they can afford to sacrifice any interest or income earned in exchange for the rare chance of winning big?”
It’s not uncommon for people to hold premium bonds for years, even decades, without considering what they could earn elsewhere.
“In effect, this is a vote against investing in the stock market,” says Moira O’Neill, head of personal finance at Interactive Investor.
Indeed, there’s a lot more to be gained from the stock market.
For example, if you put £1,000 into premium bonds, the annual 1.4 per cent compounded over 30 years would get you £1,517.
If you put £1,000 into a stocks and shares Isa, with an annual return of five per cent (the typical return from stock market investment after charges), compounding would get you a return of £4,321 over 30 years, which you can then take tax-free.
But O’Neill points out that returns look even sexier if you invest through a self-invested personal pension (Sipp) with an upfront higher rate tax relief. The same five per cent annual return would earn you £7,200 over 30 years.
So opting for premium bonds instead of the stock market means you’re effectively missing out on a decent return.
Adrian Lowcock from Architas echoes this, saying you’re essentially gambling away the return you could get in the stock market. “Savers should ask themselves whether they are they in a situation where they can afford to sacrifice any interest or income earned in exchange for the rare chance of winning big?”
While of course there are risks to the stock market, Lowcock says there are investments out there with returns that could match the million pounds up for grabs.
The thought that counts
There’s a lot of money in premium bonds that has been gifted by grandparents to give their grandchildren a financial safety net.
Yes, the thought does counts, but so does the interest rate.
In which case, a junior Isa could be a better present. NS&I, for example, offers a junior Isa with an interest rate of 2.5 per cent, which is a far more lucrative option compared to the 1.4 per cent rate on premium bonds.
“For newborns who have a minimum 18-year investment horizon, buying shares might be even more compelling,” says O’Neill. “With the FTSE 100 currently providing a dividend yield of 3.9 per cent, regular investments from parents and grandparents are likely to generate a much better final value, and could even go someway to offsetting university fees.”
So if you’re buying premium bonds to help support the financial future of your child or grandchild, you may want to weigh up the alternatives.
A major plus point of premium bonds is that the prizes are tax-free. Hollands says this makes them relatively attractive for higher-rate taxpayers, compared to taxable cash savings accounts.
“However, the tax treatment of savings interest has now been overhauled, so that basic-rate taxpayers earn their first £1,000 of interest tax-free, and higher-rate taxpayers their first £500 of interest tax-free.
“This means the tax-perks of premium bond prizes really only kick in for balances of over £71,400 for basic-rate taxpayers and £35k for higher-rate taxpayers.”
It is crucial to understand what you are potentially giving up by holding money in premium bonds
There are also plenty of other savings vehicles that are more tax efficient, and which could earn you a decent return on top.
As mentioned earlier, the upfront tax relief of a pension could more than quadruple your returns. O’Neill points out that this potential difference amounts to thousands of pounds in retirement – enough for the holiday of a lifetime, a new car, or home improvements. “And on bigger amounts invested, it could make an enormous difference to your retirement lifestyle and the ability to leave a legacy to your children,” she adds.
It is crucial to understand what you are potentially giving up by holding money in premium bonds.
So while they are aren’t a bad place to keep a small portion of your savings, ultimately they are just a bit of fun. And as O’Neill points out, in the likely event that you don’t win any prizes, your money will lose its value.