Money: Banking conduct code kills the CAR

Why the compounded annual rate of interest is doomed.

One 19th century banker described it as "the Eighth Wonder of the World". He was referring to compound interest, which is simply when interest is paid on interest.

The compounded annual rate - more frequently referred to as CAR - is often encountered in advertisements for savings accounts. It is either shown gross, that is, before the deduction of interest relating to savings accounts, or net, which means tax at 20 per cent has been deducted.

However, from 1 January 1999, no more CARs will appear in promotional material. Instead, savers scouring advertisements will encounter a new acronym - the AER - short for annual equivalent rate. It illustrates what the gross annual interest rate would be if interest were paid into the account and compounded. As the AER will be published every time a contractual rate of interest appears - and given no less prominence than any other rate - it will be easier for savers to compare the returns that they can expect when they leave the interest they earn in their account.

Compounding, of course, only influences the AER if the interest is paid more frequently than annually. In the event of interest only being paid once a year, the gross annual rate and the AER will be the same.

The demise of the CAR and birth of the AER has been brought about by the code of conduct for the advertising of interest bearing accounts. The code - which is issued by the Building Societies' Association and the British Bankers' Association - and the AER will officially make their debut at the beginning of next year.

Why the change? Because, in the past couple of years, savings products have become increasingly sophisticated and it is feared that consumers might think the returns are higher than they really are.

CARs became inappropriate with the launch of term accounts where there was a guaranteed annual rate of interest and a bonus paid at the end of a specified period.

The bonus would normally be linked to the performance of the FTSE 100. For example, the guaranteed rate may be 4 per cent a year. At the end of five years, providing the FTSE 100 rose by a certain level, a bonus of 40 per cent would then be paid.

Whatever happened to shares, the saver would be guaranteed a rate of 4 per cent each year. This would be described as 20 per cent at the end of five years. Add the potential 40 per cent bonus, and the total return becomes 20 per cent, plus 40 per cent, equals 60 per cent. This appears to be a potential return of 12 per cent a year (60 per cent, or 5 times 12 per cent).

The problem with this is that it ignores compounding - or rather in the case of this new breed of accounts, the lack of it. The fact is that the annual guaranteed rate of 4 per cent is not actually paid to the account - it is allocated and paid at the end of the term.

The promoters of such accounts were quite open in describing the mechanics of the interest payments. Whether savers fully understood the implications is another matter.

In this particular example, the payment of the interest and the bonus at the end of the five-year term resulted in the true annual return not being 12 per cent, but 9.86 per cent. This is because during the five years the account was in force, investors did not benefit from earning interest on the interest at the guaranteed rate allocated but not paid to the account. Furthermore, the payment of the potential bonus of 40 per cent at the end of the term was not really 8 per cent a year (40 per cent or 5 times 8 per cent) as this also ignored compounding.

While most of the promoters of such accounts included a CAR, in many cases this was smaller than the contractual rates. As compounded rates are usually greater than contractual rates, the fact that they can be up to 18 per cent less (the percentage difference between 12 per cent and 9.86 per cent), as in this case, it was also confusing. And so the AER is being introduced.

However, there has to be a publicity campaign to educate savers, otherwise the AER will be just another meaningless financial acronym.