Breaking the risk-free rule: Sharesave can bring high yields, as Brian Friedman explains

IT IS a golden rule of investment advice that there is no such thing as a risk-free but high-yielding investment.

Possibly the only exception to this rule is the savings-related share option scheme, or Sharesave, first introduced by the Government in 1980.

Many large employers offer Sharesave schemes to their staff and there are about two million employees in such schemes.

Sharesave has, as its name suggests, two constituent elements - a savings scheme and an employee share scheme. Under the savings element, employees enter a save as you earn (SAYE) contract. They can save between pounds 10 and pounds 250 a month. Payments are made directly through payroll deduction to the savings institution, typically a leading bank or building society.

Under the terms of the SAYE contract, the employee agrees to save for a fixed period of five years and will then be entitled to a tax-free bonus equal to nine months' contributions. This is in effect a tax-free rate of interest of 5.5 per cent, which for a basic rate taxpayer is equivalent to a return of 7.3 per cent. Employees who leave their savings in the building society or bank for a further two years will then receive an extra bonus of a further nine months' contributions, equivalent to 5.87 per cent, or 7.82 per cent for a basic rate taxpayer.

The rate of interest on an SAYE contract is in itself quite attractive - a 7.3 per cent rate of return fixed for five years at a time when base rates are just 5.5 per cent. However, the real attraction of Sharesave lies in the share option scheme element. Employees are also given an option to use the savings to buy shares at the end of the five- or seven-year period. They have to choose the period at the outset.

The price at which they can buy the shares can be set at a generous 20 per cent discount to their market value at the date the option is granted. Thus the employees' savings are guaranteed but at the same time they have the opportunity to make a possible substantial capital profit.

The rates of return can be exceptional. Even if the share price remains static during the five-year option period, the employees will still wish to exercise their share option assuming that it has been granted at the normal 20 per cent discount to market value. The combination of the savings bonus and the 20 per cent discount is equivalent to a rate of interest for a basic rate taxpayer of 19.2 per cent.

However, over five years one would normally expect the share price to increase. But what happens if the share price falls dramatically? The answer is simple. The employees do not exercise their options and merely withdraw the savings having gained from a high rate of interest.

Most of us are naturally suspicious of any investment that looks too good to be true. The following are some of the questions typically asked by employees.

Can I withdraw my savings before the bonus date?

Yes. However, as it is a five-year scheme there are penalties to early termination. First, you will lose your option to buy the shares. Second, you will only receive 3 per cent interest on your savings (provided you have saved for at least one year).

What happens if I cannot keep up my savings?

You are allowed to miss up to six months' contributions - but the end of your SAYE contract will be delayed by the number of months you miss. You will not lose your option to buy shares, but the date of exercise will be delayed until your savings are completed.

When can I exercise my option?

In normal circumstances you may exercise your option only within six months from the end of the savings contract, after either five or seven years.

Are there any circumstances in which I can exercise early?

You will be allowed to exercise your option early if you leave the company in certain circumstances. The scheme rules must, under the terms of the legislation, provide that options can be exercised early where you are leaving employment through injury, disability, redundancy, retirement or death. The rules of the scheme may provide that options may be exercised early where the company is taken over or where the business you work for is sold out from a group of companies. Under the scheme rules you may also be entitled to exercise your options early if you leave employment for any other reason set out in the rules of the scheme provided that you have been saving under the scheme for at least three years.

Brian Friedman heads the Employee Benefits Practice at Arthur Andersen

---------------------------------------------------------------------- GAINS FROM SHARESAVE ---------------------------------------------------------------------- Gross rate of Net annual Equivalent return for a share price growth tax-free taxpayer taxed at .. return 25% 40% % % % ---------------------------------------------------------------------- Falls by 20 per cent 5.5 7.3 9.2 Nil growth 14.4 19.2 24.0 1 per cent per annum 16.4 21.9 27.3 5 per cent per annum 24.3 32.4 40.5 10 per cent per annum 34.0 45.3 56.7 15 per cent per annum 43.5 58.0 72.5 ---------------------------------------------------------------------- Source: Yorkshire Building Society ----------------------------------------------------------------------

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