The UK’s Dangerous Addiction to Premium Bonds

The UK’s Dangerous Addiction to Premium Bonds

In the UK, we have a special type of savings account known as a Premium Bonds. Instead of paying you interest, it gives you the chance to win tax-free cash prizes of up to a million pounds every month. It’s essentially a lottery, but one that’s backed by the government.

Brits absolutely love Premium Bonds. In fact, 22 million people have money invested in them, which is almost 50% of all adults. These investments amount to a total of £122 billion in Premium Bonds, making them, without a doubt, the most successful savings product in the UK.

However, the appeal of Premium Bonds is primarily based on a gimmick. For 95% of people, saving money in Premium Bonds does not make any financial sense. The off chance of winning a million has resulted in millions of people under-investing in their future and consequently not being able to retire as soon as they could have.

In the following sections, we’ll explore why this dangerous addiction to Premium Bonds persists, and what people are missing out on by not choosing more sensible investment options.

How They Hook You: The Allure and Dangers of Lotteries

The Irresistible Draw of a Jackpot

In July of 2022, the EuroMillions jackpot captured the nation’s imagination. With a staggering £191 million prize, millions of people who never normally play the lottery flocked to corner shops to buy their £2.50 ticket for a chance at winning. The opportunity to dream of winning and escaping day-to-day stresses seems worth the cost.

The Dark Side: Exploiting Lower-Income Households

However, lotteries have a dark side. Lower-income households are more likely to play the lottery. In the US, households earning less than £30,000 a year typically spend four times as much on lottery tickets as those earning over £75,000. This has led to the belief that lotteries are a tax on the poor.

Preying on Behavioral Weaknesses

Lotteries are designed to prey on our behavioral weaknesses. Firstly, our brains are not wired to understand how small these probabilities really are. The chance of winning the EuroMillions jackpot is 1 in 139 million. When numbers get this high, it’s very hard for our brains to comprehend.

To put this into perspective, in any given year, the chances of you being crushed to death by a meteor falling out of the sky are just one in 700,000. You are 200 times more likely to be crushed to death by a meteor than win the lottery. The chance of you being struck by lightning is just 1 in 5 million, still 30 times more likely than winning the lottery.

The Gambler’s Fallacy

Lotteries also pull us into the classic gambler’s fallacy, where we assume that because we’ve been playing for years and never won, our luck must be just around the corner. In reality, each time you play is completely independent, and you are just as likely to win next time as you are the first time you play.

Casinos exploit this by showing the results of the last 20 spins in roulette, making players think that if red has come up 10 times in a row, they should continue to bet and bet big, when in reality each spin is totally independent.

Lotteries can be innocent fun for some, but they can also be a dangerous addiction that keeps many poor while making a few rich. As we’ll see later, Premium Bonds exemplify this issue.

The Truth About Premium Bonds: A Deeper Look into the Numbers

What are Premium Bonds?

In 1994, the UK government introduced a new savings product called Premium Bonds. Combining the allure of a lottery with the security of saving, these bonds offer the opportunity to win up to a million pounds every month. The more money saved in the account, the higher the chances of winning.

How Premium Bonds Work

Premium Bonds can hold amounts ranging from £25 to £50,000, with each £1 saved giving an extra chance at winning cash prizes between £25 and £8 million. The prize payouts equate to an average interest rate of 3.3%, and winnings are tax-free. This has made Premium Bonds incredibly successful in helping millions build good saving habits, particularly those from lower-income households.

The True Cost of Premium Bonds

While Premium Bonds seem appealing, they may not make financial sense for those who are already good at saving. The £122 billion held in Premium Bonds is lent to the government, which pays interest on that cash. This interest is then used to pay the prizes. Though the mean return is 3.3%, the median return is likely nothing at all. This makes regular savings accounts or fixed-term deposits more attractive options for most people.

Example of returns received on premium bonds

Luck’s Role in Premium Bonds

Luck plays a significant role in Premium Bonds, with larger amounts held increasing the median average annual winnings. For example, holding £10,000 results in median winnings of £225 or 2.25%. At £25,000, it’s 2.5%, and at the maximum £50,000, it’s 2.55%. This means that for many people, they may not receive the 3.3% of interest they expect, making other savings options more beneficial.

The Hidden Costs of Premium Bonds: A Closer Look

Premium Bond Returns vs. Savings Accounts

In reality, most people win nothing with Premium Bonds or earn less than the advertised rate, making regular savings accounts or fixed-term deposits a better option for many. The best rates on an easy access savings account right now are 3.5%, higher than the likely return from Premium Bonds. However, tax implications may make Premium Bonds more attractive for higher-rate taxpayers who’ve maxed out their ISA allowance.

Long-Term Consequences and Alternatives

Over the long term, the difference between returns on Premium Bonds and savings accounts can be significant. For example, holding £10,000 in Premium Bonds for 25 years would likely yield £6,000 less than in a high-interest savings account.

Many people use Premium Bonds for emergency funds or short-term savings, but holding excess cash in these bonds can distract from long-term investing. Over the last 10 years, holding £50,000 in Premium Bonds with average luck would have resulted in a real loss due to inflation outpacing interest earned, while investing in a medium-risk portfolio would have yielded higher returns.

Overcoming Behavioral Biases

Investing involves its own set of risks and is not suitable for everyone. But if your goal is to retire as soon as you can or not run out of money in retirement, holding Premium Bonds for the long term can be riskier than investing. Premium Bonds are a great tool to help people build a savings habit and are tax-efficient for higher earners, but other than that, they can be counterproductive.

It’s important to recognise and prevent behavioral biases that lead to poor financial decisions in many areas of our lives. By understanding these biases, you can become a better investor and make more informed choices about your finances.