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A Premium Bond is a lottery bond issued by the United Kingdommarker government's National Savings and Investments scheme. The government promises to buy back the bond, on request, for its original price. They were introduced by Harold Macmillan in his 1956 budget.

The government pays interest on the bond (pegged at 1% in June 2009). But instead of the interest being paid into individual accounts, it is paid into a prize fund from which a monthly lottery distributes tax-free prizes, or premiums, to selected bond-holders whose numbers come up. The machine that generates random numbers for the lottery is called ERNIE, which stands for Electronic Random Number Indicator Equipment. There are many different prizes ranging from £25 to the top prize of £1,000,000 (between 2005 and 2009, there were two £1m prizes each month - now there is just one; and prior to 2009, the minimum prize was £50). Investors can purchase bonds at any time; after 30 days, their bonds are eligible for the draw; and their numbers are entered each month, with an equal chance of winning any prize, until the bond has been cashed in.

The prize draw is conducted so that the winners of the jackpot can be notified on the first working day of the month although the actual date of the draw varies for administrative reasons. The online prize finder is updated by the third or fourth working day of the month.

From 1 January 2009 the odds of winning a prize for each bond number held was 36,000 to 1. In October 2009, the odds returned to 24,000 to 1 with the prize fund interest rate increase . Around 23 million people own Premium Bonds, over one third of the UK population. Each person may own up to £30,000 in Premium Bonds. Bonds are currently sold in multiples of 10, with a value of £1 per bond and a minimum purchase of 100 bonds (or 50 bonds when paying by standing order). When they were first introduced in 1957 they were very popular — perhaps because the only other similar games of chance available to the general public were the football pools; the National Lottery did not exist until 1994. In Irelandmarker, a similar investment scheme called Prize Bond also originated in early 1957.

ERNIE

ERNIE 1
ERNIE is a hardware random number generator. The first ERNIE was built at the Post Office Research Stationmarker by a team led by Sidney Broadhurst. The designers were Tommy Flowers and Harry Fensom. It was unveiled in 1957, and generated its bond numbers based on the signal noise created by a bank of neon tubes.

ERNIE 2 replaced the first ERNIE in 1972.

ERNIE 3 was introduced in 1988 and was the size of a personal computer; at the end of its life it took five and a half hours to complete its monthly draw.

In August 2004 ERNIE 4 was brought into service in anticipation of an increase in the number of prizes to be allocated each month from September 2004. ERNIE 4 was developed by LogicaCMG, is 500 times as fast as the original ERNIE and generates a million premium bond numbers an hour; these are then checked against a list of valid bonds to determine the winning bonds before any prizes are awarded. By comparison, the original ERNIE could generate only 2000 numbers an hour and was the size of a van.

ERNIE 4 uses thermal noise in transistors as its source of entropy for generating random bond numbers; the original ERNIE used a gas neon diode. In each case the randomness of electrons and natural unpredictable variance of the physical processes involved mean that systematic trends and similar cumulative effects that affect any pseudorandom number generator are reduced greatly, if not eliminated. ERNIE's output is independently tested each month by an independent actuary appointed by the government and the draw is only valid if the output passes tests that indicate it is statistically random.

ERNIE, anthropomorphised in early advertising and still referred to as "he" on the NS&I web site, regularly receives cards and letters from the general public.

Prize fund distribution

The size of the prize fund on offer is equal to one month's interest on all bonds eligible for the draw. The annual rate of interest is set by NS&I and is 1.5% as at October 2009. The following table lists the distribution of prizes on offer in the October 2009 draw.

Prize band Prize value Estimated number of prizes
Higher value £1,000,000 1
6% of the prize fund £100,000 4
£50,000 9
£25,000 18
£10,000 42
£5,000 86
Medium value £1,000 1048
5% of the prize fund £500 3,144
Low value £100 30,840
89% of the prize fund £50 30,840
£25 (new for April 2009 draw) 1,683,024
Total estimated value (October 2009) £52.4 million 1,749,056


History

Premium Bonds were first introduced by Harold Macmillan in his budget of 17 April 1956, with the aim of controlling inflation and to encourage people to save in the period after the war. On 1 November, 1956, at a ceremony in front of the Royal Exchange in the City of London, The Lord Mayor of London, Alderman Sir Cuthbert Ackroyd bought the first bond from the Postmaster-General, Dr. Charles Hill for £1. Councillor William Crook, the Mayor of Lytham St Anne’s, bought the second. Premium Bonds were based in St Annes-On-Sea until the late 1990s when they moved to larger buildings in Blackpool.

Scientific evidence

Two financial economists — Lobe and Hoelzl — have analyzed the main driving factors for the immense success of Premium Bonds.Every third Briton invests in Premium Bonds. The thrill to invest is significantly boosted by enhancing the skewness of the prize distribution.Using data collected over last fifty years they find that the bond bears relatively low risk by conventional risk measures.

Aaron Brown discusses premium bonds in comparison with equity-linked, commodity-linked and other "added risk" bonds. His conclusion is that it makes little difference, either to an investor or from a theoretical finance perspective, whether the added risk comes from a random number generator or a financial security price.

Premium Bond odds

In December 2008, NS&I dropped significantly the interest rate (and therefore the odds of investors winning a prize) due to the corresponding significant drop in the Bank of England base rate during the "credit crunch", leading to strong criticism from Members of Parliament, financial experts, and holders of premium bonds. Many claim that Premium Bonds are now "worthless", and somebody with the maximum £30,000 invested who has "average luck" will win only 10 prizes per year, compared to 15 in the previous year. Investors with smaller although still significant amounts will probably fail to win anything at all.

According to the Premium Bond Probability Calculator on MoneySavingExpert.com which updates the latest odds following each monthly draw, it shows the odds of winning premium bonds to be as follows:

Hold £100 over a year and the chance of winning anything is 3.28%.Hold £1,000 over a year and the chance of winning anything is 28.3%.Hold £10,000 over a year and the chance of winning anything is 96.4%.

Other meanings

A "premium bond" is also a generic term for any bond selling for more than 100% of par value, i.e., at a price greater than 100.00, which typically occurs for high coupon bonds in a falling interest rate climate.

Cultural reference

The Premium Bond and ERNIE are mentioned in Jethro Tull's song Thick as a Brick:

In the clear white circles / of morning wonder / I take my place with the lord of the hills / And the blue-eyed soldiers / stand slightly discoloured / (in neat little rows) sporting canvas frills / With their jock-straps pinching / they slouch to attention / while queueing for sarnies at the office canteen / Saying — how's your granny and / good old Ernie: he coughed up a tenner on a premium bond win.


Also the popular 80s band Madness wrote the song E.R.N.I.E. which is on Absolutely, their second album.

In a scene in the sitcom Hancock's Half Hour, Tony Hancock composes a letter to 'Dear Ernie' asking why his bond numbers still 'have not been included in the winning list'.

A scene in the sitcom Some Mothers Do 'Ave 'Em saw Frank Spencer refer to his mother regularly sending 'Ernie' a Christmas card, in the hope that she would be favoured in the draw.

References

  1. BBC News - Higher payouts from Premium Bonds
  2. BBC Inside Out - Premium Bonds
  3. http://books.google.co.uk/books?id=NNgzd0xujzsC&pg=PR13&vq=ernie&source=gbs_search_r&cad=1_1&sig=ACfU3U0YAkNtE3O_HTKvBOBmWPshqsHOqg
  4. "NS&I Premium Bond Interest rates"
  5. SSRN-Why are British Premium Bonds so Successful? The Effect of Saving With a Thrill by Sebastian Lobe, Alexander Hölzl
  6. Aaron Brown, The Poker Face of Wall Street, John Wiley & Sons, 2006.
  7. http://www.telegraph.co.uk/finance/personalfinance/savings/3569665/Premium-bonds-worthless-as-savers-see-their-chances-of-prizes-fall-drastically.html
  8. http://www.guardian.co.uk/money/2008/dec/06/premium-bond-prizes


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