Why you should forget Premium Bonds

Gambling and safety don't tend to go together. But Premium Bonds have done very well combining the two.

Investors are lured in by the prospect of winning prizes with a one million pound maximum jackpot in place of regular interest, safe in the knowledge that their capital is invested with the government. It's a risk-free bit of fun, they think.

But you are much more likely to win the Lottery than to win the Premium Bonds jackpot, so are they really the best option for your hard-earned savings?

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How do Premium Bonds work?

Since their inception in 1956, Premium Bonds have been popular with the British public.

A Premium Bond works much like a savings account. You can invest between £100 and £30,000 or £50 a month if you set up a standing order and you can withdraw that money whenever you like. The difference is that, rather than receiving interest on your money, it is entered into a monthly draw. The return on your investment comes in the form of prizes which you may - or may not - win.

A Premium Bond costs £1, so if you invest £100 you get 100 bonds. Each of these is entered into the monthly prize draw and will continue to be entered each month until you cash in the bonds.

The attraction of Premium Bonds has always been their safety. Unlike the National Lottery of course you get your initial investment back. On top of this, Premium Bonds are offered by National Savings & Investments, which is backed by the Treasury so your money is 100% safe. So in the past year, the number of people buying premium bonds has shot up, as people look for safe places to put their money.

Premium bonds: is safety better than big returns?

This safety comes at a cost, though. Low risk equals low return, and this is increasingly the case with Premium Bonds. From next month, the Premium Bond prize fund is changing. Rather than two £1m prizes each month, there will be just one on offer, with the other £1m being split into lots of smaller prizes, including a new £25 prize bracket.

The size of the overall prize fund is also shrinking. Just now, the prize fund is 1.8% of the total amount invested in Premium Bonds, but from next month it will drop to 1% to reflect falling interest rates.

The fall in the prize fund rate to 1% means that the value of prizes handed out next month will be £32.2m, down from £58.9m this month. The splitting up of the second £1m prize into lots of smaller prizes means that your odds of winning any single prize remains the same, despite the smaller prize fund but those odds aren't good.

Your chances of winning any prize in any one month are 36,000/1 for each £1 premium bond you own. But you have a measly 19bn/1 chance of winning the Premium Bond jackpot - which will halve next month. This compares with the odds of winning on the National Lottery, where you have a one in 14 million chance of winning the average £2m jackpot, and a one in 1,033 weekly chance of having four winning numbers, which pays out an average of £62.

Now of course, the big attraction of Premium Bonds is you don't lose your initial investment, unlike the pound a lottery ticket costs. But as most sensible statisticians will tell you, the odds of winning the National Lottery are so vanishingly small that it's a waste of your £1 to enter. So logically, you should ignore the chance of winning the million when it comes to Premium Bonds as well.

And if you strip out the 'thrill factor' of thinking "it could be you", then frankly, what you're left with isn't very attractive.

Why savings accounts are more attractive

The prize fund rate on Premium Bonds represents the return most people can expect to receive on their investment if they have "average luck" in effect, it's the average interest rate a Premium Bonds saver can expect to get. Now that's tax-free, so a basic-rate taxpayer would need to get 1.25% on a normal savings account to beat it or 1.67% for a higher-rate taxpayer.

But remember you will only get that return if you win some prizes. And more to the point, it's not a very good return even if you do achieve the average. Better rates aren't at all hard to find. The best instant access deal available at the moment is 2.66% (gross) from the Manchester Building Society according to Moneyfacts. So even after tax, this account beats the return on Premium Bonds, as do all the other top five instant access accounts on Moneyfacts at present. And if you haven't already used up your cash Individual Savings Account for this year, you'll also find far better tax-free homes (3.55% for the top-paying Barclays Golden Isa) for your money.

As for the safety of Premium Bonds, this is certainly an advantage. But the Government has demonstrated pretty conclusively that it has no intentions of letting any British bank go to the wall (the latest rescue of Dunfermline building society just proves the point see this week's MoneyWeek for more on this). And the maximum investment is £30,000 in Premium Bonds, whereas you can invest up to £50,000 with a bank or building society and still have it covered by the Financial Services Compensation Scheme.

So forget Premium Bonds for your savings - traditional accounts are far more attractive at the moment. But before you cash up, double check that you haven't missed out on any past winnings at the NS&I website. There are unclaimed prizes dating back as far as the very first draw in 1957 so it's worth checking.

This article is taken from our weekly MoneyWeek Saver email. Sign up to MoneyWeek Saver here

Merryn Somerset Webb is away