On a roll? Play on

The prospect of tax-free interest of 4-5 per cent above inflation still looks attractive, says Clifford German

Tessas have pushed most other forms of investment off the stage in the past month, as almost 2 million Tax-Exempt Special Savings Accounts containing pounds 18bn that were started in January 1991 began maturing and investors qualified to keep the accumulated interest tax-free. So are they a good investment?

The original Tessas were irresistibly attractive, earning interest rates of around 13 per cent. But the interest on most is variable at the provider's discretion, and current rates on offer had halved by 1995.

The best returns over five years were actually on fixed-rate Tessas, but these were relatively rare. The best returns on variable-rate Tessas for investors who had put in the maximum amounts at the earliest possible moment and had the maximum permitted pounds 9,000 when their policies matured came out as high as pounds 3,400. (The worst, thought to be the Bank of Scotland - which is understandably coy - were about pounds 2,320).

Under Treasury rules the capital in maturing Tessas can be rolled over into a second Tessa, although the interest cannot. Most investors are rolling their Tessas over, which proves that the prospects of protection of their capital against all losses, and a tax-free interest of 4-5 per cent more than the current rate of inflation still looks attractive.

Tessa providers naturally offered relatively attractive rates to persuade investors to roll the capital over with the same provider. But savers were free on maturity to transfer their Tessa to a different second-generation Tessa, without penalty.

When the first rates for these second Tessas were published last autumn many thought interest rates would rise and were not especially attracted by fixed rates of 7.25 per cent to 7.5, per cent. In fact, as interest rates generally have fallen, and quicker than most people expected, the fixed rate rollover offers started to look attractive. The best offerings from Northern Rock, TSB and have already been snapped up.

But much can happen in five years, and most investors with fixed-rate Tessas will find they will be charged heavy penalties of up to 180 days' loss of interest if they try to transfer to another provider before the next five years is up. They will also lose the tax-free status if they need to take the capital outside a Tessa before it matures.

Those investors who had not put the maximum pounds 9,000 into their existing Tessas can also roll over their capital into a new Tessa and top up the balance to the maximum permitted holding, which remains at pounds 9,000, over the next five years.

Since 1991, however, a new generation of investors has come on the scene that was too young - or too poor - to take out a Tessa. What should they make of the prospects now? Investors can start a Tessa from scratch either by contributing a lump sum of not more than pounds 3,000 in the first year, pounds 1,800 in each of the following three years and a final pounds 600 in the fifth year. Alternatively, they can contribute regular monthly savings of not more than pounds 150.

The best rates now on offer for first Tessas are available mostly from building societies rather than clearing banks, and from the smaller building societies at that. A similar pattern was seen in the first-generation Tessas that are maturing now. But rates will often be lower than on rollover Tessas. Northern Rock, for example, is still offering 8 per cent on a rollover, but new first Tessas earn only 6.25 per cent.

According to Moneyfacts, the Norfolk-based data provider, the best rates on first Tessas are 7.25 per cent fixed from Bank of Ireland, available on a minimum of pounds 500. The best variable rate is also 7.25 per cent at the moment, available from Cheltenham & Gloucester on pounds 3,000, and a similar rate can be obtained on amounts as small as pounds 25 from the Cardiff-based Principality Building Society and pounds 1,000 from the Earl Shilton Building Society in Leicestershire. Allied Trust Bank will also pay 7.25 per cent variable on a deposit of pounds 9,000, of which pounds 3,000 goes straight into the Tessa and the balance is fed in each year as soon as it becomes eligible.

All about...

Tessas

1. You can open a Tessa with a lump sum or a regular savings account.

2. Once the money has been invested, you must keep the capital for a full five years to secure a tax-free bonus. Otherwise, the rate reverts to the ordinary taxable interest rate.

3. The maximum investment in the first year is pounds 3,000, followed by pounds 1,800 in each of the next three years and pounds 600 in the fifth.

4. The maximum savings account is pounds 150 a month.

5. Once you have opened an account, the balances may be subjected to as much as 180 days' loss of interest if you decide to transfer to a competitor before the account matures.

6. The best rate available now is not necessarily the best overall.

7. Fixed rates will not change for the full five years even if other rates rise.

8. Variable interest rates can be altered at any time by the provider. They are not linked to base rates.

9. Rates are often tiered. The top rate may be available only on the maximum balance.

10. Some providers offer additional bonuses payable only on maturity.