When it comes to the typical CD investor, the number one reason that CD’s are used, is the safety that is offered within the CD. The mindset for the CD investor is like Will Rogers quoted, “I am not so much concerned with the return on capital as I am with the return of capital.” Of course the appeal is the FDIC insurance of up to $250,000. With CD rates this low, many folks are just leaving their funds in savings or checking, making little or no gains at all.
Many investors today, especially retirees, just don’t want to take the risk of putting money into the stock market after seeing two major corrections in the last 16 years of 50% or more. In the past, CD’s worked very good, but since the financial crisis of 2008, the returns have been absolutely pitiful, with the Federal Reserve lowering rates to historical levels in an attempt to energize the economy with low borrowing costs.
In fact if we take a look at current CD rates according to bankrate.com, as of the time of this writing, the highest yield available on a 5 year CD is 2%, with the average return at .85%. The highest paying 3 year CD was 1.60%, and the highest paying 1 year CD 1.22%. With CD rates this low many folks are just leaving their funds in savings or checking making little or no gains at all.
To make matters worse, CD interest is taxable to the investor so a person in the 15% tax bracket on the highest paying 5 year CD, will net 1.70%. With inflation averaging near 3%, an investor is actually losing purchasing power by investing in CD’s. At 1 percent after taxes, an investor is netting .85%.
Over time a person yielding 1% on their funds, net .85%, is actually losing around 2% per year of purchasing power. This is known as inflation risk and over time it will erode the value of a portfolio. It is more like the frog in the boiling pot, not aware of the dangers until the damage has been done. Over just a 5 year period, an investor could reduce their purchasing power by nearly 10% or more.
The Fixed Annuity vs. the CD
As of this writing, the highest paying 5 year fixed annuity rate is 3.1% (rates will vary depending upon state availability), with many carriers between 2.5% and 2.90%. Three year rates are in the 1.7 to 2% range. Overall, fixed annuity rates are 33% or higher than CD rates.
If we add in the additional benefit of tax deferral, the Fixed Annuity is pretty close to staying with inflation on 5 year or longer durations. Again over a 5 year period this can make a significant difference in a portfolio.
How Safe is a Fixed Annuity?
A fixed annuity is backed by the claims paying ability of the insurance company that you invest with. The safety record of the insurance industry company has been exceptional for providing another choice for the CD investor. (See post on the Safety of the Insurance Industry).
Most CD’s only allow you to withdraw interest only, what there is of it, during the term of the CD. Most annuities will allow you to withdraw 10% of the account value, which can free up more funds if needed by the investor.
Like CD’s, which will usually charge you loss of interest penalties, annuities will usually just have a set percentage each year, and often will be higher than a CD penalty. One very important consideration if considering an annuity is to make sure you have at least 6 months of income that is liquid and easily accessible in case of an emergency where you may need cash.
Consider the Index Annuity
Again if it is safety that we are really looking for, a fixed index annuity has the same safety features as a fixed annuity, it just doesn’t have the interest rate guarantees. The returns of course are determined by index gains tied to various market indexes, but are structured so that in declining market years there is no loss to the investor.
Normally to see returns higher than the fixed annuity, the investor may need to consider a longer duration, such as 7 to 10 years. But based on historical returns, many index annuities have performed much better than their fixed counterparts. Of course it is very important to choose index annuities that have the best upside potential. Past performance cannot guaranteed future returns. Also many of the fixed index annuities have first year bonuses ranging from 3 to 12% depending on the product and what is available in each state.