Investing for children

Friday, 6th April 2018 14:34 - by Eric Chalker

It is a natural human desire to bestow money on children and grandchildren.  How best to do so can seem challenging.  There are ‘products’ available to make it seem easy, but these come with disadvantages and, in my opinion, should be avoided.  These include Junior ISAs and all forms of ‘bare trust’ that automatically give large sums of money to 18 year olds.

There is a lot of evidence to show that the majority of children do not develop sufficient maturity by age 18 to handle sensibly large sums of money.  The law makes them adults at that age, but they can still do silly things: who can predict what influences they will be subject to before they have learned discretion from real life experiences?   Holding the money in the donor’s name is no good, because this carries a tax liability for the donor instead of the child.  The best way forward is to set up a trust and either specify the age at which the child becomes entitled to the money (my choice will always be 25), or to leave this to the trustees’ discretion.

Before talking about trusts, let’s talk about where to put the money. 

• Leaving it in a bank or building society account, or an NSI savings certificate or bond, will be completely safe, but the interest earned will be negligible.
• The same will be true for a cash ISA, except that the interest will be tax-free.
• Premium Bonds give tax-free prizes which could be as much as £1million, but, on average, winnings as a percentage are similar to bank interest rates.
• Company bonds give better interest but, as above, don’t compensate for inflation or grow in value and may need replacing on maturity.
• For a long-term investment, my unqualified preference is company shares coupled with sufficient diversification to offset the risk of an individual company failing.
• While some may choose a unit trust or other open-ended fund for this purpose, that would mean giving too much away in fees, so it’s not for me, nor an exchange traded fund (ETF) with no certainty of long-term growth.
• Closed-end investment trusts are another matter, because they minimise the need to manage a portfolio actively, as well as reasons I won’t list here.
• Best of all, perhaps, if there is an experienced investor to manage the investments over a lengthy period, the money can be put directly into a carefully diversified portfolio of selected shares, best held in certificated form, in companies which provide automatic reinvestment of dividends.

My personal experience

In 2004, I invested equal amounts for the five godchildren of my late wife, in selected shares.  There were similarities in shares chosen, but also differences.  The outcome for all the children, by age 25, was compound growth of 12 per cent per annum or better.  To my surprise, this was the case even though the investment periods ranged from just over 7 years to nearly 14.  In 2004, I had been investing for less than three years; with the benefit of more experience now, I know I could have done better, so I do not regard this outcome as exceptional.  It is, though, four times the rate of inflation.

Those were investments in company shares, with some occasional changes determined by me in discussion with the children’s parents.  More recently and much more carefully, I chose investments for a 4 year old, intended to avoid the need for any changes because neither I nor the parents want to be actively involved.  After a great deal of thought and research, I selected two investment trusts, out of, very surprisingly, only four which I found to provide automatic reinvestment of dividends. 

As readers will no doubt want to know what the choices were I will give them, but this is not a recommendation to buy.  The performance since investing (at a point I selected very carefully, because over several months of daily observation there had been a good deal of volatility) is extremely pleasing, but I cannot predict what will happen in a major global downturn such as some expect, nor whether the regions in which they are invested will live up to their present prospects.  The investments are Scottish Investment Trust (SCIN) and Witan Pacific Investment Trust (WPC), both chosen for their geographical coverage.

Since March 2016, excluding dividends, these investment trusts have given annualised growth of 20 per cent, despite an interim setback.  If this were to continue, on average over the years, the original investment would have been multiplied by almost 13 at age 18 and 46 at age 25, with dividend reinvestment making the actual outcome much, much greater.  This would mean that, even without dividend reinvestment, a gift of, say, £3,000 could rise to £38,500 by age 18 and very much more than that with dividend reinvestment.  This is a startling prospect for a young person at that age and should cause parents and grandparents to think carefully about how to handle the original gift. 

Use of a trust

To avoid automatic transfer of the financial assets at age 18 and yet still avoid income and capital gains affecting a parent’s or grandparent’s tax liability, it is necessary to set up a trust.  The trust can be a ‘single beneficiary’ trust with a specified date for release of the assets, or a ‘discretionary’ trust giving the trustees full and lasting control (needing at least one additional beneficiary, who can be nominal).

The cost of setting up a trust, which I would not expect to exceed £1,000, can be taken from the money for which it is being set up.  All trusts have to be notified to HMRC.  With a single beneficiary, the tax and filing responsibilities are minimal.  Although a discretionary trust has some big advantages, filing tax returns can be onerous.  Taxation requirements will change over time, but HMRC currently allows those coming into possession of trust assets to defer capital gains tax until an asset is sold by the beneficiary; this is known as Hold-over Relief, details of which should be sought elsewhere.

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016

 

 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.