How to ensure your little ones grow up into big spenders

Parents' choices now will affect the money their child has at 18, says David Prosser

Let's hope Gordon Brown doesn't expect his baby son, John, to be as patient as everyone else's kids. Although the Chancellor first announced child trust funds (CTFs) in the 2001 Budget, the savings scheme does not finally launch until 6 April, the first day of the new tax year.

Let's hope Gordon Brown doesn't expect his baby son, John, to be as patient as everyone else's kids. Although the Chancellor first announced child trust funds (CTFs) in the 2001 Budget, the savings scheme does not finally launch until 6 April, the first day of the new tax year.

However, more than 30 financial services companies have already launched CTF products. Once families have received government vouchers, they can pre-register for the scheme with one of these firms.

The idea is to kick-start family savings. All children born on or after 1 September 2002 are entitled to CTF vouchers worth at least £250, rising to £500 for low-income families. Children born since 1 September but before 6 April will also get a small amount of additional interest, to reflect the fact they have not been able to invest the vouchers since the scheme was first announced.

Children will then get another payment from the government at age seven, which is likely to be £250 or £500 again. And in last week's Budget, Brown announced a third payment for 11-year-olds, though he hasn't yet said what this will eventually be worth.

The money must be invested with a registered CTF provider - parents who fail to do so will find the Government opens a default account on their behalf. Parents can't make withdrawals from CTFs at any time, and they aren't entitled to control what their children ultimately do with the money, which is theirs at age 18.

On its own, the government's contribution is hardly a fortune. Invested cautiously over 18 years, a CTF might be worth less than £1,500 when its owner turns 18, if it only includes government cash. But ministers hope parents will make additional payments into CTFs: family and friends can put up to £1,200 a year into each child's fund. All the money then grows tax-free.

Children lucky enough to have their funds topped up with the maximum contributions can look forward to more substantial windfalls. Assuming a fund earns returns averaging 6 per cent a year, it would be worth almost £40,000 by a child's 18th birthday according to independent financial adviser Chase de Vere. But first parents must choose an account from one of the three types of CTF available.

Eight banks and building societies are offering cash accounts, paying an annual interest rate, just like a conventional savings account. The interest is tax-free and the money cannot fall in value.

Alternatively, there are about 20 stakeholder CTFs. These offer access to one or more investment funds, usually with exposure to the stock market, but there are strict rules about the assets in which managers may invest on children's behalf.

The value of the funds can fall and rise, but stakeholder CTF providers have to start reducing children's exposure to shares once they reach age 13, to limit the chances of a stock market crash seriously damaging the investments when they have little time to recover.

Stakeholder CTFs are not allowed to make any charge other than an annual fee of no more than 1.5 per cent, though few CTFs of any kind are more expensive than this. In addition, parents who want to top up their kids' funds can't be required to make minimum contributions of any more than £10.

Stakeholder funds carry a government endorsement in that they are the default option for families who do nothing. However, the third option available to parents, stock market CTFs, offers exposure to a wider range of investment funds with fewer restrictions.

Choosing a CTF for your children is a two-step process. First, pick the type of account you want. Then identify the best account in this category (see opposite page).

Financial advisers are almost unanimous in arguing that CTFs should have some stock market exposure. While it is true that share prices can rise and fall, in the past at least, the stock market has outperformed all other asset classes over longer-term periods. As 18 years is a long period, shares are the best option, says Ben Yearsley of independent financial adviser Hargreaves Lansdown. "Even if you end up transferring funds out of shares into lower-risk assets once your children reach their teens, they are still likely to end up better off than they would with a cash account," he argues.

Justine Fearns, of Chase de Vere, says: "Although we are in an environment where we can expect low returns across the board, I would still recommend a fund that invests in equities or combines equities and bonds, as the most appropriate route."

Chase de Vere calculates that one of the best cash accounts today, from Nationwide, would produce a fund worth £36,008 for a child at age 18, assuming the CTF is topped up to the maximum contribution levels and that interest rates remain constant.

A stock market CTF earning a conservative 6 per cent a year would be worth £38,809 in 25 years' time, Fearns adds. But if the fund earned the 8.8 per cent a year averaged by the typical UK fund over the past 18 years, it would be worth much more - £51,427.

There are no guarantees with stock market investment. But Fearns argues: "Returns of 8.8 per cent are not necessarily unrealistic, even with today's lower-return environment, as the past 18 years include the three-year bear run we've just been through and the various Black Mondays and Wednesdays we have also suffered."

Despite such advice, many parents are reluctant to invest in shares. Research from the Association of Investment Trust Companies (AITC) shows 58 per cent of parents who have already received CTF vouchers plan to open a cash account. Most of these told the AITC they thought investing in shares was too risky, or that they didn't understand the stock market.

If you do prefer the cash option, make sure you get the best possible interest rate. Several providers are currently offering accounts that pay bonus interest for the first couple of years, but once this period comes to an end, these CTFs will be less competitive.

Parents need to monitor the performance of children's savings carefully, whatever type of account they choose. CTFs are transferable - parents can move money between providers in search of a better deal, usually without penalty. Doing so makes sense if better returns are available elsewhere. One final issue, Yearsley says, is what happens to CTF money when your kids get their hands on it. "Usually, when you save on behalf of children, you retain control over the money, but that's not the case with CTFs," he warns. "You have to give your children access to the money at age 18 and you have absolutely no right to a say in what they do with it."

For this reason, Yearsley thinks parents should consider simply using CTFs for the government's contributions and then making additional savings elsewhere.

Although CTFs are tax-free, children are entitled to their own tax allowances, he points out. Even if they end up making substantial profits from other types savings, there will be ways to manage the eventual tax bill, he says.

'We'll play the market'

Rona Macdonald considers the cash she is receiving in CTF vouchers for her 15-month-old son, Matthew, as a bonus.

"This is money we wouldn't otherwise have, so we want to make the most of it," she says.

Rona, from Croydon, plans to open a CTF giving Matthew exposure to the stock market, because she thinks this offers the best long-term potential returns. "This is an 18-year investment, so there is plenty of time to ride out a few short-term bumps," she says.

But with just a few days to go until the CTF scheme is up and running, Rona still isn't sure about which provider to choose: "There seems to be a lot of choice and it's confusing; I think the government should be giving people more help in picking the right provider."

'Cash safer than shares'

Debbie Leftwich lives in Ipstones, Staffordshire with Amy, six, and Jared, who was two in May. Amy is too old to qualify for a CTF, but Debbie and husband Graham plan to open a cash account for Jared with Britannia Building Society .

"I like the fact Britannia is guaranteeing 6 per cent a year for the next two years," says Debbie. "I know people say they might earn more on the stock market, but there are no guarantees when it comes to shares.

The couple have already set up two savings accounts for their children. They now plan to set up regular top-up payments from Jared's savings account to his CTF.

THE BEST CTFs

* Two building societies tie for first place on cash CTFs. Britannia pays 6 per cent a year, though this includes a 1.25 per cent bonus only payable for two years. Nationwide is paying 5 per cent, plus 1 per cent if parents top up the accounts with at least £240 a year. Hanley Economic and Ipswich building societies also offer good rates to savers in their local areas.

* Financial advisers are unimpressed with stakeholder CTF providers. Darius McDermott, of Chelsea Financial Services, says: "They all do the same sort of thing and investments on offer are unimaginative." He says it is "ridiculous" that stakeholder CTFs from providers offering computer-run index-tracking funds, including Halifax and Nationwide, cost 1.5 per cent. This is five times more than what investors would pay for the same type of funds outside a CTF. He recommends four stock market CTFs: the Children's Mutual, Pilling & Co, Reyker Securities and the Share Centre.The downside to the latter three is there may be fees on both the CTF and underlying funds.

* For parents wanting to invest their children's money ethically, the only direct option currently is the Children's Mutual, which has a link to the friendly society's ethical fund through its stock market CTF.

* www.moneyfacts.co.uk has a complete list of all CTF providers.