Don't worry about falling returns on child trust funds

Since child trust funds (CTFs) were launched in 2005, they have been lauded as an excellent way to save for your child's future. The government gives you a £250 voucher which you can invest in either stocks or a cash account. The government adds another £250 on your child's seventh birthday.

Parents, grandparents and others can then add up to £1,200 a year between them to the trust, and on the child's 18th birthday they get access to all the money. What's more, income and capital gains are all tax-free. HM Revenue & Customs (HMRC) reckons that 4.3 million child trust fund vouchers have been issued so far, of which three million has been invested by parents (if you don't invest after a year, the Government does it for you).

However, last year's stock market slump wiped a third off major indices such as the FTSE 100, and took a similar amount off the value of many child trust funds invested in equities, according to Jeff Salway in The Scotsman. So should you stick with equity-based funds?

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Child trust fund investors can ignore falling stock markets

The current panic about recent stock market drops stirred up by some commentators looks overdone. CTFs don't mature i.e. your child can't touch the money for 18 years. That's plenty of time for the stock market to correct itself and make gains.

"In the past it has paid to view a long-term investment over many years, and not a few months," says Neil Lovatt of Scottish Friendly in The Scotsman. If you panic and switch to cash, you will simply lock in your losses to date and miss out on future gains.

However you still face the choice between two different types of share-investing CTF accounts: standard and stakeholder. With a standard share investing account you pick a provider and they invest your cash in shares over the 18 years.

With a stakeholder account, your chosen provider will also invest in shares. But once your child is 13 the money is gradually moved into lower risk investments such as cash and bonds, so it is protected from stock market losses as the payout date approaches.

Another key difference lies in account charges. Stakeholder accounts have capped charges the annual management fee cannot exceed 1.5% - whereas standard equity accounts have no such limit. So anyone buying a non-stakeholder product should always check charges carefully. And don't be distracted by give-aways such as free toys and vouchers when picking any CTF, whether cash or equity based. Charges and for cash accounts, the interest rate offered are far more important.

So what to buy? For pure cash accounts, the best interest rates are available at moneyfacts.co.uk. High payers currently include the Hanley Economic Society, offering 5.5%, and the Yorkshire Building Society, paying 4.5%.

For a stakeholder plan, Hugo Shaw of Bestinvest favours the F&C FTSE All-Share Tracker CTF which is "cheap and simple to understand". Outside of stakeholder plans, tread carefully. "Charges are generally too high and the market is quite narrow," says Roddy Kohn of IFA Kohn Cougar in The Guardian.

The biggest problem with child trust funds - control

But apart from potentially high charges, a much bigger CTF drawback is that you have no control over what your child does with the money when they get their hands on it on their 18th birthday. You may prefer them to use it to pay off debts, but they may have other ideas. Like buying a car, playstation or funding their next party.

So if your own finances are sufficiently secure in the wake of the credit crunch (and this is by far the most important thing there's no point on saving for your child if you don't have enough money for your own long-term needs) then there are better ways to save spare cash than through a CTF.

For example, Isas have similar tax advantages to CTFs, so if you haven't used up your £7,600 annual allowance (or £15,200 if there are two of you) then there's no reason to top up the CTF and this way you get to keep control of the money.

Help your child save for their old age

Alternatively, a good longer-term option, if you and perhaps grandparents are willing to chip in, is a pension. You can put up to £3,600 into a pension for a child or grandchild each year, and since contributions qualify for basic-rate tax relief, that means a cash contribution of just £2,880 a year.

Do this for 18 years from birth, and even if you then stop contributing for the next 37 years, by the time the child is 55, the fund could be worth £950,000, assuming an annual growth rate of, say, 6%, says pensions analyst Nigel Callaghan of Hargreaves Lansdowne in the FT.

Giving to a pension is an especially attractive idea for solvent grandparents, as it allows them to hand money down the generations while potentially avoiding having to pay inheritance tax on it. That's because contributions can qualify as what HMRC calls "normal expenditure out of income", making them exempt from inheritance tax. And your child gets a head start on the one thing that most of us don't save enough for our old age.

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