Much like Marmite, Premium Bonds have a habit of dividing opinion. We asked Anna Timms, Director of Investment Sense to look at Premium Bonds in more detail and consider whether they are an attractive method of saving.

She starts with a quick reminder:

What are Premium Bonds?

National Savings & Investment’s (NS&I) Premium Bonds have long been the cornerstone of many a person’s savings, over 22 million of us hold them, totalling approximately £41 billion.

Premium Bonds are a deposit based investment which pays out tax free prizes rather than interest.

When someone invests in Premium Bonds they are allocated a series of numbers, one for each £1 invested.

The prizes vary in size from £25 to £100,000 with one jackpot prize of £1,000,000 per month, the prize fund is currently equal to an annual interest rate of 1.5% (Source: NS&I)

What are the benefits of premium bonds?

One of the most important benefits for those who buy Premium Bonds is the fact that capital is 100% guaranteed.

Furthermore savings can be accessed at any time and the returns are tax free for all. Winnings can be used to buy additional bonds, which increases the chance of further wins

Premium Bonds can be held by parents or grandparents on behalf of children, which makes them a popular choice when saving for the younger generation.

Many see the real benefit as the ‘fun factor’, there is always the chance of winning the £1,000,000 jackpot!

What are the disadvantages of premium bonds?

Whilst the prizes are tax free and there is always the chance of winning the jackpot the indicative average interest rate, of 1.5%, is currently significantly lower than inflation. This means that if you were to receive the average amount of prize money the value of your savings would actually fall in real terms.

A further disadvantage is the fact that the maximum amount of money which can be held in Premium Bonds is £30,000 per person.

Are premium bonds a good way of saving?

The average return offered by Premium Bonds is significantly below the current rate of inflation.

It is also possible to open savings accounts which pay a much higher rate of return than Premium Bonds, even taking into account any tax due on the interest.

In simple economic terms better returns can be found elsewhere.

However, traditional deposit accounts don’t offer the chance to win a £1,000,000 jackpot, despite the hugely long odds; this is what attracts many to Premium Bonds; the fun rather than the economic return.

Premium Bonds can also be useful for higher rate tax payers who have used their Cash ISA allowance for the year and want instant access to their money. The average interest rate of 1.5% is broadly equivalent to the best net rate of interest on an instant access account and there is always the chance of winning that jackpot!

What should I be doing with my savings this year?

Simple, the key is to try and beat inflation.

Getting a return better than inflation is always important, however the economic times we currently live in make this peculiarly hard. CPI (Consumer Price Index) is currently 3.7% with many experts believing it will rise further before any falls materialise.

Inflation at 3.7%, not a problem you might think, we all remember when inflation was much higher. However it is a problem when Bank of England base rate is just 0.5% and most savings accounts are paying a return less than inflation.

When you factor in tax it is extremely hard to get a return which will help your savings keep pace with inflation, just look at the gross interest you need:

Tax rate

Gross interest rate needed to beat inflation

0% / Cash ISA investment 3.7%
20% 4.625%
40% 6.17%
50% 7.4%

For 0% tax payers or ISA holders to get an inflation beating interest rate savings need to be tied up for two years.

For 20% tax payers, savings need to be tied up for five years to get an inflation beating return.

There are currently no deposit accounts available which provide 40% and 50% tax payers with a return sufficient to combat the effects of inflation.

The problem is made worse by the fact that many believe interest rates will rise during the course of 2011 and into 2012, leading to an understandable reluctance to commit to a fixed rate now.