Are Premium Bonds worth it?

Premium Bonds from National Savings & Investments are one of the most popular financial products of all time. It is estimated that nearly half of all adults in Britain have them, with over 26 million people holding at least one Premium Bond.

They are undeniably popular. Their allure comes from a combination of capital security and the chance to win tax-free prizes. Since the global financial crisis really got going last year, security of cash has become an even more important factor when deciding where to keep your money.

But are they worth it? Whilst lots of us own them, many people tell us that they have never won a prize. When compared to the most competitive interest rates available from ordinary savings accounts, the interest rate used to calculate prizes is fairly pitiful. In this article we separate fact from fiction and help you understand whether Premium Bonds are the right home for your cash.

A history lesson

Before we look at the basics, here is a brief history lesson.

Premium Bonds were launched on 1st November 1956 after Harold Macmillan announced them in his April Budget report as a method of reducing inflation and encouraging thrift. £5m worth of Premium Bonds were sold on the first day.

The first prize draw did not take place until June 1957, but by that time over £82m had been invested in Premium Bonds. Over 23,000 prizes were awarded in that first draw and the top prize was £1,000.

After this positive start, the total amount invested in Premium Bonds peaked at around £4bn in the early 1990’s before really taking off in terms of popularity. By 2008, £40bn was held in Premium Bonds.

The basics

A big attraction of Premium Bonds is the relative simplicity of their design. The rules are fairly easy to grasp even if you are usually intimidated by financial products.

Anyone who is 16 years old or over can invest. Under 16’s can also own Premium Bonds if a parent, grandparent or legal guardian buys them on their behalf.

The minimum investment is £100 and the maximum holding per person is £30,000. There is no set investment term and each month your Bonds are entered into the prize draw.

Your money invested in Premium Bonds does not attract interest each month. Instead, you stand the chance of winning a tax-free prize (more on these in a minute).

However, your capital is very secure. Money within Premium Bonds is backed by HM Treasury. This means that there should be no real concerns about default risk or having to resort to the Financial Services Compensation Scheme (FSCS) for compensation.

Meet ERNIE

ERNIE is the Electronic Random Number Indicator Equipment. Since the introduction of Premium Bonds in 1957, ‘he’ has been the one responsible for selecting prize winners. Today, National Savings & Investments is using the fourth generation of ERNIE.

His randomness is ensured by a monthly check by the Government Actuary’s Department (GAD). They then issue a certificate to confirm the randomness of the machine, which is needed before NS&I is able to pay out prizes.

The monthly prize draw includes one £1m jackpot. The other prizes range from £25 to £100,000. For October 2009 the total prize fund was £52.4m and 1,749,056 prizes were distributed in total.

The odds of winning any prize each month (which could be £25 or £1m) have been calculated at 24,000 to 1. In simple terms, this means that for every 24,000 eligible Premium Bonds there is one prize.

This can be compared to the National Lottery, where the odds of winning any prize are in the region of 54 to 1. However, this is a difficult comparison to make because with the National Lottery you lose your ’stake’ each time you enter.

The odds of winning the Premium Bond £1m jackpot each month are in the region of 40,000,000,000 to 1.

Are they worth it?

This is the one million pound question. The prize fund is calculated by reference to a notional interest rate applied to all holdings in Premium Bonds. This interest rate is tax-free and currently stands at 1.5%.

This means that, regardless of your income tax status, if you hold £100 in Premium Bonds you might expect an average annual return of £1.50. If you hold the maximum £30,000 then your average annual return would be £450. Of course many people will receive nothing and some will receive more. It’s a gamble.

Compare this to one of the most competitive instant access savings accounts at the moment; West Bromwich Building Society is offering 2.85% gross with its Branch Easy Access Saver. For a non-taxpayer with £30,000 in savings this means annual interest of £855. Basic rate taxpayers would expect £684 and higher rate taxpayers would receive £513 of net interest.

There are some key differences between Premium Bonds and savings accounts. With the savings account you would know in advance what level of interest you should expect to receive in the year. With Premium Bonds you can have an average prize expectation in a given year. Equally, you might get nothing or you might receive more.

From a capital security perspective, and because the maximum Premium Bonds holding is £30,000, the equivalent amount in savings with a UK financial institution would come under the £50,000 limit of the Financial Services Compensation Scheme (FSCS).

The inflation argument

One argument often made against Premium Bonds is, whilst your capital remains secure and invested for future prize draws, the ‘real’ value of your cash is eroded over time by price inflation. This is because a rate of interest is not physically applied to your cash but future increases to the value of your capital depend entirely on winning prizes.

In the current economic environment, this is less of a concern. The Retail Prices Index (RPI) measure of inflation was -1.4% for the twelve months to September 2009. This means that, even if your Premium Bonds did not win a prize during the past twelve months, the purchasing power of your capital would have improved.

During times of positive price inflation this would not be the case. In fact, it doesn’t get much better if your cash is in a bank or building society account earning interest. Cash is not the place for holding money longer term if you want to maintaining purchasing power and protect it from inflation erosion.

Should you buy them?

Premium Bonds have mass-market appeal. They combine a simple financial product, capital security and the chance to win tax-free cash prizes. In fact, there isn’t a huge amount not to like about them.

They might not be the right home for all of your money, but as a way to take more of an interest in your financial planning and participate in a lottery without losing your stake, they are pretty tough to beat.