A decade has now passed since the 1990 Finance Act introduced us to the tax exempt special savings a...
A decade has now passed since the 1990 Finance Act introduced us to the tax exempt special savings account (Tessa). Designed to promote low-cost savings, the Tessa was an instant hit with the public, and over the years billions of pounds have effectively been removed from the tax system.
As expected, the high street banks and building societies dominated the Tessa market. Faced with the option of having our hard-earned savings either taxed or tax-free, it was not difficult to see why millions of us readily signed up to this five-year savings plan. Tax-free savings had previously been the preserve of the equity investor, through Peps, but now the more cautious investor was able to participate.
The Tessa's success was built on its simplicity, universal appeal and, with the retail banks and building societies fully behind it, the mass marketing potential. The early 1990s were also a period of relatively high bank base rates (double-digit throughout 1991 and most of 1992) and this made the Tessa a compelling low-risk solution for many.
Initially, the choice of Tessa was limited to either fixed or variable rate. Therefore, when base rates were at the top end of the cycle, the client could lock-in to high rates via the fixed option. Conversely, when economic conditions merited a tightening of monetary policy, the variable rate Tessa offered a rising tax-free return. Hindsight has shown that in the first tranche of Tessas, the fixed rate option was best, while, for the rest of the 1990s, there was less to choose from between the variable and fixed rate alternatives.
It was at this time a third Tessa option appeared on the market the equity-linked Tessa. While fixed and variable-rate Tessas offered a solid tax-free return for investors, the performance was never likely to match that of even the most average stock market fund and nor should it given that there was no risk to capital. However, the continuing development and use of derivatives in the retail market meant there was now a cost-effective way to offer Tessa investors the steady 'deposit-like' returns and the potential to participate in the growth of the stock market.
Now the client had all the benefits of a guaranteed return of capital plus the potential to have growth in the chosen stock market index added on top as a bonus. During the 1990s, two of the main providers of this new type of Tessa were HSBC and Bristol & West.
Based on the usual five-year period, the equity-linked Tessa typically offered investors a comparatively lower equivalent annual return (45%) plus a possible uplift at the maturity date, which in turn was dependent upon the performance of the stock market index over the five years. The minimum guaranteed return was found by constructing a portfolio of financial instruments with maturities that dovetailed with the Tessa's own maturity date.
In addition to these specialist instruments, the provider would use option contracts to generate the upside exposure to the market. In common with all derivative contracts, the option would only have value if the index finished above a certain level, otherwise it would expire as worthless with the original premium lost.
The HSBC Tessa Plus contract initially offered an equivalent of 5% a year plus the potential of up to another 30% at the end of the five years a maximum return of 55%. Working in a similar way, Bristol & West's Guaranteed Equity Rate Tessa also offered an annual interest equivalent to 5%, but unlike HSBC, the maximum uplift, based on the performance of the FTSE 100 Index, was unlimited.
With the FTSE 100 Index showing annual compound growth of 14.7% over the past 10 years, it is not surprising to learn that the returns from these two equity-linked Tessas have comfortably outperformed the average maturity values from traditional deposit-based Tessas.
Accepting the lower guaranteed rate and participating in the growth of the equity markets made a significant difference to the final pay out clients will now receive on fully funded Tessas. Care is needed, however, because there can be no guarantee that the next five or six years will offer such a favourable environment for equities. That said, even in the worse case scenario, where markets fail to grow at all, the client is assured that their initial investment is always secure.
Equity-linked Tessas offer a unique and highly attractive way of combining the low risk elements of a deposit account with the superior growth potential of the stock market equity-style growth without the sleepless nights.
No more Tessas
The Election of 1997 not only brought a change in Government but also a commitment to add breadth and depth to the long-term savings market. While some may have questioned the underlying motivations, the Treasury sought to extend the principles established by Peps and Tessas, consolidating them into the individual savings account (Isa). Therefore, from 6 April 1999, no new Tessas could be started. Existing Tessas will be allowed to run their full term and, at maturity, the client will face a number of new options.
l The maturing capital from the Tessa (up to £9,000) can be invested in mini cash Isas. This will not affect the annual £7,000 Isa allowance but it does mean that you cannot take out a maxi Isa in that particular tax year.
l Using a maxi Isa, the Tessa's capital can be held under the cash component without impacting the overall £7,000 Isa allowance. However, doing this means that the rest of the Isa must be with the same provider and so means some diversity is lost.
l Regulations now permit the setting up of a new Tessa-only Isa, which runs independently of the Isa for the tax year. This option offers greater investment flexibility as it makes no restriction on your choice of maxi or mini Isa provider.
Given the flexibility, we see the Tessa-only Isa as being the most popular Tessa solution for those adviser-led clients. Bristol & West has calculated that in the first quarter of 2001, about £21bn of Tessa money will mature and this clearly is an important opportunity for the adviser to add real value for their clients and direct them towards the best option.
Winners and losers
So, who are going to be the winners and losers in the mad rush to secure maturing Tessa money over the coming months? The banks and building societies will of course be leading the charge and with such captive audiences, it will be no surprise to see the majority of Tessa maturities simply rolled over into their respective in-house cash Isa. There will be some competition among providers and headline rates will dominate the decision-making process for many investors. But it would be a shame if clients failed to consider the merits of the equity-linked Tessa-only Isa. While the longer term picture is more difficult to predict, in the short term UK interest rates appear to be on a downward trend.
Slowing global growth, corporate profit warnings and the very real danger of a recession in the US all combine to suggest that the Bank of England's Monetary Policy Committee (MPC) will be persuaded to maintain a more 'doveish' bias for the immediate future. This would imply that locking into, what would be, historically low interest rates could be folly.
The variable rate option may offer more than the fixed rate over the next few years, but now that the MPC is independent and its raison d'tre is keeping inflation under 2.5%, there can be few who would expect that UK interest rates would regain the heady levels of the early 1990s. This is particularly true if you factor in the UK's possible entry to the euro.
Against such an economic background, the equity-linked Tessa-only Isa options appear particularly attractive.
World stock markets have taken a battering, and with many analysts suggesting that much of the bad news is already priced in, now seems the right time to lock-in to a low stock market level and reap the rewards of long-term equity-linked investment. Taking such a long-term view, there seems to be limited downside and much upside potential from such a strategy.
Tessas have been exceptionally popular savings vehicles and the opportunity to retain this tax-free status for up to £9,000 is one most clients would be well advised to take.
That the rolling over of Tessa capital into an Isa or Tessa-only Isa does not interfere with the current £7,000 Isa allowance is warmly welcomed and means that a married couple could shelter as much as £46,000 from the tax system over the coming months.
As our clients become more knowledgeable and demanding, investment products and the way in which we use them to formulate appropriate strategies also need to be more sophisticated and innovative. Many investment advisers may have previously shied away from the Tessa market but now, with the ability to apply equity-related rationale, we are now in a position to offer clients a real alternative to the traditional deposit-based offerings.
Graeme Cumming is investment manager at Save & Invest
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