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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 the IFA is often paid a nice little commission on each sale he or she makes. Selling investments for children to new parents who want to provide for their children must be one of the easiest sales to make. 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. As these are endowments, they suffer from all of the problems associated with such policies. 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"!
Pensions for children
The introduction of stakeholder pensions back in 2001 made investing for children even more appealing. Previously, you had to be earning money and paying tax to be able to benefit from having a pension. With stakeholder pensions, it is no longer be necessary to pay any tax in order to receive basic rate tax relief on money paid into these plans. Importantly there is no lower age limit for making contributions. This means that you can make contributions for children. The critical issue is that even though a child may not be paying income tax they will be able to benefit from an income tax rebate into their stakeholder pension. This means that an investment of £100 into the stakeholder pension fund would actually cost you only £78.
One of the primary sources of funds for my own investments for my children is Child Benefit. Currently, it is £16.05 a week for the first child and £10.75 a week for any subsequent child. So, basing this on our first child, Catherine, we'd invest £16.05 a week, or a rounded-up figure of £835 a year. After grossing this to take advantage of the tax rebate of 22%, we would get an equivalent investment of £1,070 a year.
Now imagine if we had been able to start investing this when she was born until the Child Benefit finished at the age of 18 in a stakeholder pension, and she then did not make any further contributions until she retired at the age of 50; how much would it be worth? (For simplicity let's ignore the fact that the rate of benefit may change in the future.)
At the age of 18, assuming an 8% annual rate of growth and a 1% annual management fee, the fund would be worth about £29,450. If we stopped contributing and left this to continue growing at 8% a year less the 1% annual charge, then by the time she was 50 years old the fund would have grown to over £350,000. Even allowing for inflation over the next 50 years, this is still a sizeable fund and certainly has the potential for her to be guaranteed a comfortable retirement.
All of this sounds very attractive, but of course there are potential problems.
1. Buying a stakeholder pension for your child means tying the money up until they retire. At the moment this is a minimum age of 50. What happens if disaster strikes and the money is needed for other uses before then? If it is a pension fund the money is not available -- of course, with the benefits of compounding, this may be a real benefit in disguise.
2. You have to buy an annuity with your pension pot. So, we don't have complete freedom to do what you want with the proceeds, unlike you would do with an ISA, for example.
3. We are looking a long way ahead. In 50 years a lot can happen, governments change, and regulations -- particularly apparent "loopholes" like this one -- get altered. It may be that the rules are tightened to take away the opportunity for this in the future. If they are, what would happen to the contributions already made?
4. What if over the 50 years the tax relief on pension contributions was removed?
5. What happens if the "fund" that you choose does not perform very well over the full 50 years?
6. What happens if the Government abolishes Child Benefit or, more probably, if it becomes means-tested?
Child Trust Fund
Plans for the Child Trust Fund have recently been announced by the government. Every baby born after 31 August 2002 will get some money, although the first payments are unlikely to be made until 2005. It's difficult to say whether this will be a worthwhile option at the moment as details are thin on the ground. In any event, it makes sense to get a head start and start saving now rather than waiting a couple of years.
Summary
Investing money for your children for the long term in the stock market is one of the best presents that a parent can give to their offspring. Small contributions made for a child, left to compound, can build up into quite large funds; funds that can be used to give your child a head start, to help them fund the purchase of a house, help with the cost of going to university, or provide for their old age.
The so-called "safest" investment vehicle -- putting your money in an interest-bearing bank account -- is in one sense the most guaranteed of them all to be a losing proposition. The "risky" investment in the stock market will, over the long term, usually prove to have had the lower risk.
Children born today in Britain can expect to live for 80 years or more, so start saving and investing for them when they are young. Teach them how to manage their own money, and help them benefit from the miracle of compounding!
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