Premium Bonds

“Cash is king” is a common statement about the value of cash as a long term holding.  As it happens, it’s a statement I generally disagree with if the interpretation is that cash is best for everyone in all circumstances, because it isn’t.  Everyone does need to keep a certain amount of cash readily available for emergencies, though, and that’s where cash truly is king.  In this article I am going to make the case why your emergency fund should be in NS&I Premium Bonds.

You can of course consider any number of other cash solutions, from cash in your current account through to long-term fixed rate bonds, and I hope to point out why these are less suitable in my opinion.

What is an Emergency Fund?

Before we go any further, it’s worth revisiting what an emergency fund actually is.  After all, we are going to be discussing whether Premium Bonds make a good home for your emergency fund, so it makes sense to consider what an emergency fund is and how large it should be.

At its core, an emergency fund is, as the name suggests, a fund that you access in an emergency.  The exact nature of an emergency is up to you, but many people consider things like urgently needing to replace a broken-down car or white good.  It should also include income provision if there is a risk that your existing income ceases, e.g. losing your job or falling ill.

Because an emergency fund is used urgently when used at all, it is important that you have near instant access to it when required.  In addition, you need to be able to rely on the value of the fund, therefore it is not appropriate to put the emergency fund into any sort of investment asset, as these could easily lose value and reduce the effectiveness of your emergency fund.

In summary, your emergency fund needs to:

• Provide a lump sum if you suddenly need to replace broken goods.
• Provide an income if your earnings cease for whatever reason.
• Immediately accessible so that if an emergency occurs it’s there for you.
• Safe from investment volatility so that the value is known at all times.

In terms of size, there’s no fixed answer to this.  Some people are comfortable with an emergency fund of 3 months salary, wile others want enough of an emergency fund to cover 3 years of expenditure.  You should have a chat to your financial adviser if you want to work out how much of an emergency fund you ought to be holding.

What Options are There?

Reading down the list of requirements, it’s clear that most investments are excluded because of the risk of loss.  As such, the list of suitable options are as follows:

• Physical cash
• Cash in current account
• Cash in instant-access savings account
• Cash ISA
• Premium Bonds

Physical cash, i.e. a stash of literal banknotes stashed in a safe place, are a very bad idea.  Not only are they at risk if damage occurs in the place you have stored them, holding cash in your home over a certain level may not be covered by your home insurance policy.  As such, your emergency fund could quickly become a major problem if kept in physical cash.

Current accounts typically pay next to no interest, so they are likely to lose purchasing power every year as inflation continues to affect the value of Sterling.

Instant-access savings accounts are the first option that I think has a lot of merit.  These accounts generally offer higher interest rates than current accounts (not that this is saying much), and usually have no other restrictions on the amount you can put into them, so they can seem ideal.  The drawback to these accounts is the fact that they are taxable, meaning any interest you receive can be added to your taxable income for the year and subject to your marginal rate of income tax.

Cash ISAs are essentially savings accounts (either instant access or for a specified term), therefore you can elect for an instant access cash ISA.  With cash ISAs, any interest received is exempt from income tax, therefore this directly removes the drawback of normal savings accounts.  However, the use of an ISA brings its own drawback into play, namely that you are limited to contributions totalling £20,000 a year into all ISAs, cash and stocks and shares alike.  This means that it can take time to build up to your desired emergency fund, and if you ever need to withdraw a significant amount from your emergency fund you may find that you are unable to replace it after the emergency passes due to the contribution limit.

Premiums Bonds are the last item on my list, and I will spend the rest of the article talking about them in particular.

What are Premium Bonds?

Premium Bonds are, at their core, just a savings account with a few odd features.  This means they are cash holdings and you will never see a reduction in value due to investment market movements.  They are provided by National Savings and Investments, meaning they and any other cash you hold with NS&I are fully underwritten by the Treasury rather than the Financial Services Compensation Scheme.

Premium Bonds have an underlying interest rate, currently 3.8%, but this isn’t paid to you as the account holder.  Instead all the interest is paid into a central prize fund and prizes are then assigned according to a random number generator called ERNIE.  This prize fund includes top prizes worth £1 million, which means that in a given month your interest could be anywhere from £0 to £1 million, regardless of your holding size.  Each £1 you have in Premium Bonds gives you one unique number for the prize draw, and if your number is drawn you win the corresponding prize.

The actual mathematics of what you can reasonably expect to earn in interest payments from Premium Bonds over the short term is very complicated, but there are plenty of resources you can use to work out what the likelihood of winning a certain cumulative value of prizes is for a given holding over a given term.  Over the very long term, you would mathematically expect to approach 3.8% as the headline rate, but this would require you to hold on for long enough to win £1 million at least once, which is extremely unlikely.

Notwithstanding the issue of not knowing quite what you will actually earn in interest, Premium Bonds come with an additional benefit, namely that the returns are not subject to income tax.  As such, whatever you win is yours with no tax to pay.

Premium Bonds are not without restrictions, but in this case the restriction is a total ownership limit of £50,000 per person, i.e. £100,000 for a couple.  For most clients, this is more than enough of an emergency fund to feel comfortable, but even if you have a larger requirement, this is a fine start.

Why Premium Bonds for my Emergency Fund?

Looking back at the requirements for an emergency fund listed earlier, Premium Bonds:

• Have a limit of £50,000 per person, which can be taken as a lump sum or as regular withdrawals.
• Are instantly accessible in case you need the money.
• Do not incur any sort of investment volatility.

On top of that they are tax free, which means they meet all the requirements for your emergency fund with the added benefit of generating a tax-free return.

In short, they are essentially perfect for this purpose, so if you aren’t already holding Premium Bonds for other reasons, you ought to consider using them for your emergency fund.

If you want to talk about putting together your overall financial profile and working out things like your ideal emergency fund, get in touch and we’ll start the discussion.