Alternatives to CDs
Bank CDs have been garnering more attention these days, not so much for their yields, which are somewhat unspectacular in this low interest rate environment, but more for their value as a safe haven from the ravages of a volatile stock market. But investors are experiencing CD shock which is the sinking feeling they get when they see the interest rates being offered. Although their first concern is the safety of their principal, many investors are looking to alternatives to CDs that would enable their money to work a little bit harder.
The one vehicle that draws the most direct comparison to a bank CDs are annuities. Both are issued by financial institutions, offer fixed rates and safety of principal, but the similarities end there. When considering annuities as an alternative to CDs you have to examine all of their characteristics.
Annuities are contracts offered through life insurance companies that guarantee a secure stream of income for life, or a specified period of time in exchange for a lump sum of money. If the need for income is off in the future, it can be deferred and the funds can accumulate in a tax deferred account earning a rate of return.
Fixed Rate Returns
Both CDs and annuities offer fixed rate returns which can be guaranteed for a specified period of time, and in both cases, the longer the term, the higher the rate. There are two differences worth noting for investors concerned about earning competitive rates and the risk interest rate declines. Banks generally set their rates based on the prevailing market for short term interest rates. As a result, the yields are more sensitive to the daily changes in short term rates. Life insurers generate annuity rates from the overall yield generated from their bond portfolios which consist largely of long term, higher yielding bonds. As a result, the yields on annuities tend to be higher than those on CDs and less sensitive to the short term movements of interest rates.
Additionally, when short term rates decline, the yields on CDs will shrink, so, an investor holding a five year CD to maturity will likely have to roll his funds into a lower yielding CD. Annuity rates can also decline; however, most annuity contracts come with minimum rate guarantees that prevent rates from dropping below a specified floor. Historically, annuities yields have always been higher than CD yields.
Taxable versus Tax-Deferred
The earnings on CDs are taxable when earned. Annuities are treated much in the same way as qualified retirement plans which allow earning to accrue without current taxation. The difference over a long period of time can be significant when earnings are allowed to compound without the encumbrance of taxes. Annuity earnings become taxable when they are withdrawn.
Access to Funds
Most fixed term CDs require that the funds be held until maturity in order to receive the full credit of the fixed interest rate. There is limited access to interest earned. The annuity contract is based on a commitment of funds for a minimum period of time, however, it does allow for withdrawals without penalty if they are limited to 10% of the current balance. After a certain period of time (7 to 10 years), the withdrawal penalty vanishes allowing for unlimited access. At any time, if the annuity owner is under the age of 59 ½, the IRS will levee a penalty fee of 10% on the amount withdrawn to the extent that it is interest earnings.
Safety of Principal
Most everyone is aware of the protection CDs receive from the FDIC. Up to $100,000 per account is fully insured by the federal government. As the number of bank failures continues to accelerate (several hundred in the period 2008 to 2010), FDIC insurance has taken on more prominence and its long term viability has come into question.
Annuities have no federal protection; however, each state has established its own guaranty fund which provided protection on annuity deposits from $100,000 to $200,000 depending on the state. Additionally, and perhaps more importantly, life insurance companies are very heavily regulated and must comply with strict state requirements for reserves and capital surplus. Diligent state oversight ensures that life insurers will have enough to meet their obligations. To date, no annuity holder has ever lost a dime of their principal.
Many retirees use bank CDs to generate a current income from interest earnings. As interest rates decline, they risk a decline in their income. Annuities can be converted to income that is guaranteed not to decline over the life of the annuitant. Additionally, the income from an annuity is comprised of both principal and interest so that it is only partially taxed and can amount to a higher income payout depending on the age of the annuitant. Also, annuity income is exempt from the Social Security tax calculation and CD income is not.
This straightforward comparison doesn’t go into many of the details of annuities that are important to know before making any investment decisions. Certainly, your own needs, preferences, time horizon, priorities and risk tolerances are the most important consideration when choosing any investment. However, if you are considering bank CDs for the safe part of your portfolio, it might make sense to consider annuities as an alternative.
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