Time to invest in a Tessa

Safe but boring, tax-free but inflexible - over the past few years, the verdict of self-styled stock market sophisticates on Tessas has always had a mild ring of contempt to it. But, as Iain Morse reports, Government plans to introduce a new Individual Savings Account (ISA) mean the humble Tessa may be about to make a final comeback.

Is it finally time for a Tessa? After all, there can't be too much wrong with a tax-free deposit account. Moreover, although personal equity plans (PEPs) will have to be transferred into the new Individual Savings Account from April 1999, existing Tessas will be allowed to run the balance of their five-year term.

In effect, this minor loophole means savers will be able to shelter part of their cash in a tax-free haven for a few more years. The burning question remains, however, that of which Tessa to choose.

The most common Tessa (tax-exempt special savings account) is the straightforward, variable-rate one. This rate may be the same no matter how much you pay in. Midland Bank, for instance, offers a current flat rate of 7.75 per cent on all Tessa deposits over pounds 100.

Other providers offer stepped interest rates, depending on the amount invested. Pay in the maximum each year - pounds 3,000 in year one and up to pounds 1,800 in subsequent years - and you qualify for the highest return. For example, Stafford Railway Building Society starts at 6.5 per cent on amounts up to pounds 3,000, rising to 7.6 per cent on the maximum balance of pounds 9,000.

The basis on which interest is calculated can also vary. Cater Allen Bank pays compound interest - where interest is added on the interest - on a monthly basis. According to Cater Allen, this increases returns, pushing a current variable rate of 6.697 per cent up to around 6.85 per cent.

This basis for interest-rate calculation becomes important if you are saving into a Tessa on a monthly basis and, in effect, lending this money interest free to the provider until the next award of interest to your account.

Also, if rates are falling, say by 0.5 per cent in two successive six- month periods, an annual account will pay interest for the past year at the lower rate. On an investment of pounds 9,000, this could cost pounds 45 in lost interest in comparison with an account calculating interest monthly.

Some variable-rate Tessas offer bonuses if you leave both invested capital and tax-free interest in the account until maturity. Chelsea Building Society offers 5 per cent of the amount invested in the first year: if you put in pounds 3,000 in the first year, this means a tax-free bonus of pounds 150. Nottingham Building Society offers 0.25 per cent of the maximum invested.

Things become more complicated when the bonus is paid on the interest itself: First Trust Bank offers a 5 per cent bonus on the total interest paid after five years. According to MoneyFacts, the statistical information provider, a maximum return of pounds 2,359 for five-year Tessas maturing this January would have delivered a bonus of pounds 117.95.

How to choose between such offers? At its simplest, if you believe interest rates will rise over the term of your Tessa, a variable-rate account makes sense. If you think rates will fall, fixed-rate accounts are better. Most experts believe rates will drop in the next year, but because fixed- rate Tessas currently pay a lower rate than variable ones, you need to be careful when doing your sums.

The best fixed-rate Tessa is currently available from NatWest Bank, paying a compound rate of 7.45 per cent, but only for deposits of over pounds 6,600.

Then there are escalator Tessas, which pay rising rates of interest over the five-year term. Most ask for a minimum investment of the full pounds 9,000, and the amounts paid tend to start at between 6 and 6.25 per cent in year one, rising to between 7.25 and 9 per cent in year five.

Here too care is needed: averaging out returns over five years shows that these accounts offer no more than an annual return 7 per cent. Unless providers improve their rates, these are to be avoided.

Equity-linked Tessas are slightly more risky: they offer a combination of tax-free interest with what amounts to a gamble on the stock market. Most pay low rates of interest, usually not more than 4 per cent, but offer further gains based on the amount by which one or more stock market indices rise over the Tessa's term.

Bristol & West's First and Follow-On equity Tessa allows a minimum investment of pounds 3,000, and pays the greater of either 100 per cent of the average growth in the UK's FTSE 100, the US's S&P 500, and Japan's Nikkei 300, or 20 per cent of the value of your first year's investment. Given the current state of the Japanese economy, this is one for enthusiasts.

HSBC links its equity Tessa to the FTSE 100 alone. Alastair Fraser, head of business development at HSBC, argues: "This represents a relatively low risk exposure to equity markets, with absolute capital security - after all there has been no five year period since 1979 when the index did not rise." This is true, but the Tessa only offers a 1 per cent bonus for each 1 per cent increase in the FTSE 100 - and not until it has risen by at least 20 per cent over its five-year term.

Tessas can be transferred from one provider to another, without loss of tax relief. But, as we have seen, there may be penalties imposed which wipe out any tax saving made on the account.

For example, Northern Rock levies a fixed charge of pounds 30, plus a charge for administrative time spent arranging the transfer. If you had invested pounds 1,000 into its account, receiving pounds 68 gross interest on a variable rate of 6.8 per cent, transfer penalties would leave little gain.