FOOL SCHOOL
Investing For Children (Part 2)

September 11, 2002

By Nigel Roberts (NigelTMF)

The practicalities of saving for children

So what are the options available to parents who are in the lucky position of being able to invest some money for their children? The easiest way to look at this is if I give you a real life example of what my wife and I are doing for our own children. We have three, Catherine, our eldest, and the twins, Maiya and Luke.

When the children were born, family and friends gave them a number of cash presents. We saved this money, resisting the temptation to run out and buy nappies with it. We also save the child/faimly benefits that the Government so kindly gives to us and any additional cash presents that they are given. Over the next 18 years, we hope that this will grow into a sizeable sum that will set them up for the rest of their lives.

Open a high-interest savings account -- using a Bare Trust

We opened building society accounts for each of the children, into which we pay all of the money. The accounts were opened in our names but designated with the child as the beneficiary. This is known as a Bare Trust, and means that while we have control of the account, the money is treated as theirs, and they will be able to take control of it when they reach 18.

When we opened the account, we completed the R85 Inland Revenue form given to us by the building society so that any interest would be paid gross. Parents should be careful here -- if you make a gift to your child that earns the child income of more than £100 in any one tax year, the whole amount would count as your own income for tax purposes. With two parents, there is a £200 limit. This rule only applies to gifts from parents, not other relatives or friends, and on money given from other sources children have the same income tax allowance as adults. But don't forget, if you are saving the Child Allowance this will be treated as a gift from the parent to the child!

If your child is a little bit older and is starting to learn the value and meaning of money, it is worth introducing her to the banking system by getting her to participate in opening the account and pay in money on a regular basis.

But how do you choose which bank or building society account?

There is a huge range of children's savings accounts available, and I am sure every bank in the country must have some form of account targeted specifically at children. Often these come with a range of attractive free gifts. But as with all Foolish investors, you must teach your child to look beyond the value of the free gift and teach him or her to choose an account that pays the highest level of interest. Some banks and building societies pay rates that are very unimpressive, while others (often the mutual building societies) will pay a high level of interest on only £1, with instant access to the money. Indeed, children's accounts are often much more generous in their terms than adult accounts. So Fools -- shop around!

Stock market investments for children

Once we have a reasonable sum built up in the account (say, about £1,000), we buy shares in blue chip companies, which we plan to tuck away and more or less forget about until they come of age. If you are investing money for your children we would strongly recommend that you adopt a long-term strategy and be willing to tuck the money away for a minimum of 5 years -- preferably much longer. Remember the table from part 1. I say "more or less" forget about them because if you are truly Foolish you won't forget about them completely. You should always monitor the performance of the companies you are invested in: the rule is long term buy and hold unless you can find somewhere better to invest the money.

What stock market investments can you choose?

There are a number of investment choices that suggest themselves. Being Foolish, we would consider an index tracking fund to be the best option, as long as you are investing for the long term.

Buying shares -- or unit trusts -- in a Bare Trust

If you are buying shares for your child (or unit trusts, for that matter), you buy them in your name. Normally you add the child's initials after yours to designate that the shares are held on your child's behalf. For example, for our eldest daughter, the shares are held in the name NG and BB Roberts (CSR). The "CSR" indicates that we are the registered owners of the shares or units but Catherine Sheree Roberts is the beneficial owner. This is the same form of trust -- a Bare Trust -- that we used to set up her building society savings account. A Bare Trust is easy to set up and needs no involvement from a solicitor. As parents we act as bare trustees, looking after the investment on behalf of the child until the shares (or units) can be registered in the child's name. This will be when she reaches 18 (16 in Scotland) and we as trustees are obliged to hand over the assets of the trust.

Bare trusts in this form are very basic but are legally binding. The trustees, in this case my wife and I, are the registered owners of the shares, but Catherine is the beneficial owner. In other words, she is the person to whom all the benefits from the shares will go. This method of putting the child's initials after the adult's name is enough to indicate beneficial ownership by the child, and it is not necessary to inform the Inland Revenue that a bare trust has been set up.

If you wish, you can write to the Inland Revenue advising them of the existence of the bare trust. More complicated legal trusts can be set up to specify other restrictions. However, these are more complex matters both legally and in terms of taxation, so in this case I would suggest that you seek the relevant professional help.

Investing in Unit Trusts

You can also invest in a unit trust rather than investing directly in individual shares. Usually, the minimum investment amount is a lump sum of £500 and regular monthly payments of £20 a month. Remember that investing for your child is no different from investing for yourself -- you should apply Foolish principles, invest for the long term and beware of charges. The beauty of investing for your child is that children have time on their side and you can keep adding to their investments over the years. Index tracker unit trusts are available. Look for one that charges no initial or exit fees and has an annual management charge of 1% or less, and also beware of the dreaded extra charge that many impose for monthly investments. There are Independent Financial Advisors who will be happy to sell you a unit trust and refund to you most of the initial commission that they receive.

Tax

Unfortunately, you cannot open an ISA for your child, as these are not available to anyone under 18. Therefore, at some stage, tax may become a consideration. Children will not usually have to pay capital gains tax. Like adults, they get the same annual capital gains tax (CGT) allowance as an adult. But usually it will be some time before your child has built up a fund that is big enough to generate gains in excess of this. Mind you, with regular Foolish investing, who knows? Remember as well that capital gains tax is only triggered when the gain is realised; in other words, when you sell some shares.

What about Friendly Societies?

The name "Friendly Society" is very evocative. It makes you imagine that the organisation must be just that -- friendly! Surely the products that these societies offer must be friendly too? One of the most popular products offered by Friendly Societies is a savings scheme for children. These are given special tax benefits, and so many parents and grandparents are persuaded to invest their money for their children or grandchildren.

Friendly Societies are no different to life and other insurance companies, and their businesses are indistinguishable in nature. They offer a range of savings options, usually funded on either a monthly or annual basis and running for a 10-year term. Friendly Society funds have a special tax-free status, but the maximum contribution level is low -- at the time of writing, either £25 per month or £270 lump sum per year.

If you have ever had an Independent Financial Advisor call on you after you have recently had a baby, you will know that IFAs seem to love Friendly Society products. They say that it is because of the tax advantages they offer, but I think there is another agenda here -- the IFA is paid a nice little commission on each sale he or she makes (unless it's one of the marginally more Foolish fee-based flavour of IFA). Selling investments for children to new parents who want to provide for their children must be one of the easiest sales to make, and every little bit of extra commission that an IFA can make helps to provide a better life for their children! Some Friendly Societies also sell their products direct to the public through well-funded advertising in newspapers and magazines.

Friendly society "baby bonds" aim to give exposure to equity investment through a fund, and provide tax-free growth and payouts. You can choose between a with-profits plan and a unit-linked plan that you take out for a minimum term, usually ten years. There is a maximum age limit of 16 for these baby bonds, and most will provide limited life insurance cover for children over 10 years old.

What you need to recognise is that these products are endowment policies, being sold to people who often do not really realise what they are being sold. After everything that the Fool has said, would you buy an endowment? No, of course you wouldn't. So why would you want to buy an endowment for your children? As these are endowments, they suffer from all of the problems associated with endowments. They have high charges and are inflexible; in the first year you can expect to pay at least half your premiums in set-up charges, and in the early years you'll probably get back significantly less than you paid in premiums if you have to cash the policy in. In almost all cases, if you were to invest the money in a children's building society account, even if you had to pay tax on the interest, you would get a much better return! So much for being "Friendly"!

All Fools should be wary about using so-called Friendly Societies for their investments. In particular, beware the investments that are targeted at extracting money from parents and grandparents for children where the products offered are distinctly unfriendly. These schemes exploit your wish to provide for your children or grandchildren while in reality they are exploiting your pocket for the benefit of commission-hungry salespeople (IFAs) and to fund the operation of the Friendly Society.

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