Premium Bonds – are they really worth investing in?

With June seeing the limit on Premium Bonds rising from £40,000 to £50,000, we look at the merits of investing in them and see what sensible alternative investments there are.

Premium Bonds are a government-backed savings scheme. You can buy some premium bonds and, instead of interest accruing, you are entered into a monthly draw to win prizes, ranging from £25 to the jackpot of £1 million. The more you buy, the more likely you are to win, with no limit to the amount of prizes you can claim.

The draw each month is made in a lottery style, with two £1 million prizes, five £100,000, nine £50,000 moving down to just over two million £25 winning numbers. Next month, July 2015, the prize pot is £61.9m spread across 2,117,145 different bonds.

One of the merits is being government-backed, through National Savings & Investments. Premium Bonds offer “100%” security for your money. This makes for a risk-free investment, attractive to many investors, plus the added thrill of a monthly lottery and the knowledge that you could win £1 million. On top of this, prizes are tax-free, so all your winnings can go straight to your back pocket.

However, a possibility of winning big can also mean a probability of winning nothing at all. While the prizes and figures may look large, the sheer number of Premium Bonds in existence whittle your monthly odds of a prize down to 1 in 26,000. Even then, 88% of the total prize fund is paid in the ‘lower’ band; prizes of £100, £50 or £25.

The prize fund itself is based on 1.35% of the value of Premium Bonds in issue, therefore if you have ‘average’ luck, your annual return on investment will only be 1.35%. Despite the fact that interest rates remain at historic lows, even this amount is less than that of many cash ISAs. Importantly, it is also below the Bank Of England target inflation rate of 2%. While the UK has flirted with deflation in the last couple of months, most believe this will be short lived, and any movement back towards the target rate will mean Premium Bond holders will lose money in real terms, as the ‘value’ of £1 will be falling at a faster rate than your winnings are likely to come in.

There is also the matter of reinvestment to consider. While the prizes may be a welcome boost, it is likely that, as the majority of winnings are under £100, they are more likely to be spent than used to buy more Premium Bonds and therefore the returns made may not be generating further gains.

So what are the alternatives? Well, as I’ve already mentioned, a number of cash ISAs are paying over 1.35% (though still a pretty low rate) and, with a couple’s annual allowance over £30,000, a good chunk of your investments could be sheltered from tax immediately.

For those willing to take on more risk, the possible returns are much higher, although not guaranteed. I’ve selected three Elite Rated funds, two multi-asset in nature – Investec Cautious Managed and Jupiter Merlin Income – and one corporate bond – Invesco Perpetual Corporate Bond – to demonstrate what you could have achieved with a lower to medium-risk investment fund over the past 10 years*.

The results are quite compelling, showing that over the previous 10 year period, your money could have nearly doubled in the Jupiter fund, and up over 65% in the other two. If we then look at how much could be earned from the current Premium Bonds rate for the next 10 years we see some differences.**

Admittedly, interest rates are at historically low levels, but the 10 year figures for the funds do include the financial crisis. A remarkable figure is that the all the funds gained more in the previous three years of investment than Premium Bonds are expected to in 10, at current rates.

These investments can also be held in an ISA wrapper making any revenue generated also exempt from further taxation.

Obviously these funds do carry risk, considerably more so than a Premium Bond, and the value of the investment can go down as well as up, but the potential of making some money over the long term is evidently much greater.

So, Premium Bonds may be a safe and secure product, with the allure of a big prize, but for a rational investor, it is not an investment in its truest sense. If you are looking for returns on your money, then a fund, held in an ISA will generally offer a stronger opportunity.

*Source: FE Analytics, figures correct as at 8th June 2015.

**Premium bonds rates and prizes are subject to change. Return percentages were last changed in 2008 and prizes in 2014.