Testing times for Tessa holders

The Tessa 2 season is fast approaching and building societies and banks are feverishly finalising plans to hold onto the money they already have and attract a fresh wave.

The popularity of Tessas (tax exempt special savings accounts) when launched nearly five years ago means pounds 16bn will mature in the first quarter of next year, according to an estimate from the Building Societies Association.

The challenge for Tessa providers is how to keep hold of this money and prevent it being scooped by more tempting Tessas from other providers or by competing investments.

In January 1991, the most competitive Tessas paid interest at 15.3 per cent. Now the best rate from Britannia Building Society is a fixed 7.65 per cent.

Most variable-rate Tessas pay less than 7 per cent. By contrast the new kid on the block, corporate bond personal equity plans, provide a tax-free yield in many cases of 8 per cent and more.

Nationwide Building Society recently asked MORI to find out what Tessa- holders planned to do. The research showed that 74 per cent of people intended to reinvest all or part of their capital, but only 61 per cent were planning to reinvest it in a Tessa.

That still means up to pounds 10bn could find its way back into Tessas. Most building societies and banks accept that they are going to have to provide a choice of Tessas, including variable and fixed rates.

A spokesman for Abbey National said: "The bog-standard Tessa of five years ago is not enough. Customers are more sophisticated and want to know what a Tessa can do for them."

Nationwide has said it will offer a variable-rate Tessa 2 and a range of fixed-rate products if market conditions allow.

Portman Building Society is offering its Tessa holders a follow-up Tessa paying guaranteed interest at 7 per cent in the first year, rising by 0.5 per cent a year to 10 per cent in year five. The full pounds 9,000 capital has to be reinvested and is guaranteed to grow to pounds 13,300.

Take-up of this competitive offer is running at more than 60 per cent, the Portman says, but no decision has been taken on whether to extend it to the public at large.

Robert Fleming is openly touting for Tessa 2 business. Its fixed rate of 7.5 per cent a year guarantees a maturity value of pounds 12,920 on an investment of pounds 9,000.

HSBC Asset Management has also put down its marker, saying it intends to launch the first Tessa with returns determined by the FT-SE 100-share index.

It will guarantee a minimum return of 25 per cent over five years, even if the stock market bombs. The maximum return is 50 per cent, however much the market moves up.

An investment of pounds 9,000 could therefore grow to between pounds 11,250 and pounds 13,500, but staying the five-year term is essential in order to reach such returns.

Alan Gadd, managing director of HSBC Asset Management, says the figures may prove conservative and the actual deal when introduced in late January could offer more.

These are the few who have shown their hand, however. Most other Tessa providers are still debating how to pitch their terms.

Whether or not to invest in a Tessa 2 depends on the Tessa-holder's circumstances five years on and the merits of competing investments.

Maturity values of fully topped-up Tessas will be close to pounds 12,000.

If holders re-invest elsewhere, similar tax-free products include corporate bond peps, National Savings guaranteed income bonds (GIBs) and zero-dividend preference shares.

Corporate bond Peps offer higher yields than Tessas - Commercial Union Monthly Income is currently paying 8.9 per cent - but most also levy initial and annual charges. They are more flexible as they need not be held for five years, but are not guaranteed and capital erosion is a danger.

Corporate bond Peps can also only accept investment of pounds 6,000 a year per person, so they can shelter half of the full Tessa maturity value.

National Savings GIBs are akin to Tessas in that they are five-year deposit accounts.

The forty-second issue pays a fixed 5.85 per cent a year and the index- linked eighth issue pays 3 per cent above inflation. GIBs also lock the money away for five years and presently pay around 7 per cent fixed per annum.

Zeros, one of the classes of share in a split-capital investment trust and available through stockbrokers, can be bought and sold at any time and are free of income tax though liable to capital gains tax.

The trusts have 10-year lives and their redemption values on winding up are not guaranteed, but are usually well covered. Gartmore Scotland, redeem- able in July 2001, is presently yielding 8.1 per cent with a generous 125 per cent cover.

Alternatively, Tessa-holders may want to raise their risk profile and try equities. Reinvested in a Pep, the tax-free attractions of a Tessa would be retained while potential returns over time would increase.

Likely investments would be a high-income Pep like Perpetual Income, Schroder Income or M&G Equity Income.

Such a course would, however, catapult Tessa-holders into the world of stock market volatility and unpredictable returns.

After considering the alternatives, they may prefer to stick with a high street deposit account and lap up the loyalty bonuses.

Portman is adding a 2 per cent bonus on the entire balance of Tessa 1 on maturity, worth up to pounds 232.

Nationwide has now promised Tessa 1 customers who reinvest in its Tessa 2 for the full five years an interest-rate bonus for Tessa 2 on maturity and a special incentive.

Over the coming weeks all Tessa providers will have to set out their stalls. Savers should wait and see the full offering before jumping.

They have six months after maturity of their first Tessa to make up their minds.

What you need to know about Tessas

Tessas (tax exempt special savings accounts) were launched in January 1991 as a five year tax free deposit account.

Savers can put in up to pounds 9,000, with a maximum first year deposit of pounds 3,000, up to pounds 1,800 in each of the next three years and pounds 600 in the final year. Interest can be withdrawn net, but the tax free status is lost if the capital is touched.

Tessa 2 will be available from January. Holders of existing Tessas can reinvest their capital up to a maximum of pounds 9,000 in a Tessa 2 in the first year provided they do so within six months of the old Tessa maturing.

If they miss the rollover opportunity, the first year investment limit reverts to pounds 3,000 for Tessa 2s.

The old investment limits apply to new savers.