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Thursday, 9 February 2017

HOLD THOSE PREMIUM BONDS

Premium Bonds will give a poorer return from the May 2017 draw. So are they still a good place for your savings?


The changes to premium bonds announced on 8 February do not affect their value as a good place for your cash savings if you fulfil three conditions
  • You can buy the maximum £50,000 or close to it. 
  • You pay higher or additional rate income tax. 
  • You have used up your personal savings allowance with interest on other savings outside ISAs.

The changes are
  • the nominal interest rate is cut from 1.25% to 1.15%
  • the distribution of the prizes at the lowest end has been altered
The restructuring has been done so that the chances of winning the lowest £25 prize each month will be slightly higher from May while the chance of winning £50 or £100 will be slightly lower.

The effective interest rate earned if you discount all the other prizes apart from £25 is 0.98%. It is tax-free so is the equivalent of taxable interest is 1.22% for a basic rate taxpayer, 1.63% for a higher rate taxpayer, and 1.78% for a top rate taxpayer. This is fractionally better than the current effective rate for the £25 prizes. If you hold the maximum £50,000 you can expect to win just over nineteen £25 prizes in a typical year. At the moment the expectation is slightly fewer than nineteen £25 prizes in a year.

How do they work?
Each month the £62 billion of bonds earn interest, currently at an annual rate of 1.25%. That will fall to 1.15% from 1 May 2017. Each month the interest of £65 million or so is put into a prize fund. That total is then shared at random among the bondholders as prizes. Each bond has a 1 in 30,000 chance of winning a prize in each monthly draw. Prizes are paid tax-free so the return is better for higher rate (40%) taxpayers who have other savings to use up their £500 tax-free savings allowance or additional rate (45%) taxpayers, who get no tax-free savings allowance. 

At the moment the fund is divided so that 93% of the prizes are for £25 which uses up 75% of the money. Two million £25 prizes were paid in February 2017. Nearly 71,000 prizes each of £50 and £100 were also paid. Those three prizes use 90% of the prize money and accounted for 99.75% of the prizes.

From May those three prizes will still take the same proportion of the money and prizes. But the number of £50 and £100 prizes will fall to just over 20,000 each. The number of £25 prizes will rise to 2.2m, which will be 98% of the prizes, and take 85% of the prize money. 

Higher prizes range from £500 to £1 million. Although winning a million is a nice thought, forget it. You won’t ever win that prize. Even with the maximum £50,000 bonds you would have only an even chance of winning a million after 55,000 years. That was when humans stopped having sex with Neanderthals and 10,000 years before we started painting in caves. The odds of winning the second prizes of £100,000 are the same as the million pound prizes.

So forget about the higher prizes. Concentrate on the stream of £25 prizes. That will be slightly better from May than it was before. 

Interest rates
When considering the actual interest earned in any realistic timeframe it is those three lower prizes that should be counted. With £50,000 bonds you can expect to win a £50 or £100 prize once every five years in future - it was two years. That means the effective interest rate - the money used for the prizes you might win - is 1.04% from May compared with 1.13% before the changes. So if you can take a five or ten year view of your money that is equivalent to earning 1.29% taxable interest for a basic rate taxpayer, 1.73% for a higher rate taxpayer and 1.88% for a top rate taxpayer. 

Those are not bad rates for an instant access account. Money in Premium Bonds can be taken out without notice at any time.

With 50,000 bonds you will expect to win 20 of those lower prizes a year – the same as before May. The vast majority will be for £25. Of course chance will not produce an even return. But over time that should be the average. Here is the monthly 14 month prize record of one £50,000 holding I am familiar with 3,1,1,0,0,0,1,1,2,5,2,2,2,2. All were for £25. It is a rate of 0.9% a year tax free.

Prizes
Even with a maximum holding you can only expect to win £500 or £1000 once every 22 years (up from 20 years). The larger prizes of £5000 and more are far more sparse. If you had bought £50,000 premium bonds in 770 when King Ahlred was on the throne of Northumbria and sending missions to the continent you would expect to have won just one larger prize by now. You will wait another 1247 years until the year 3264 for the next.

With smaller amounts of bonds, prizes of course are much rarer. £100 gives you an even chance of winning a £25 prize every 25 years. With one bond bought when when Stonehenge was built you might have expected about two prizes by now.

So Premium Bonds are still good for people who can afford to buy the maximum who are higher and top rate taxpayers and who have used up their personal savings allowance with interest on other savings. That probably means £30,000 to £50,000 in other savings products on top of any cash in ISAs. Additional rate taxpayers do not get the personal savings allowance. More than half the bonds are held by people who have at least 30,000 of them.

Randomness
ERNIE (Electronic Random Number Indicator Equipment) who draws the winning bonds each month is not a computer. However hard they try computers cannot produce genuine truly random numbers. So ERNIE uses a process which was invented by a Bletchley Park codebreaker called transistor thermal noise to create truly random events which are then counted and combined in turn into bond numbers. Every month the Government Actuary checks the prize list for randomness before the prizes are paid.

Because every bond really does have an equal chance of of winning there is no point in cashing in 'unlucky' bonds and buying new ones. Doing that also means there is a month between selling and buying when the bonds are not in the draw. So it worsens the odds of winning.

Personal Savings Allowance
The personal savings allowance which began in April 2016 means the interest on savings is tax free up to £1000 for basic rate taxpayers and £500 for higher rate taxpayers. So the tax-free prizes are of most value to those who have other savings which have used up those allowances. Additional rate taxpayers do not get the personal savings allowance. So premium bonds are very good for them.

Buying
You can buy Premium Bonds online at www.nsandi.com where you can also check for prizes and trace lost bonds. You can also buy them by phone or post. You must be at least 16 years old. Parents, grandparents, and great-grandparents can buy them for children but only parents can do that online.

version 2.0 (earlier versions published in 2015 and 2016)
9 February 2017