CD Annuities vs. Fixed Annuities
A new annuity wrinkle is the CD annuity, a type of fixed annuity with a superficial resemblance to a bank CD. What is it? How does it differ from the traditional fixed annuity? How does it compare to a bank CD? For what class of investor is the CD annuity well-suited?
Definition of CD Annuities
CD annuities are a type of fixed annuity whose credited interest rate is fixed for a term identical to the surrender penalty period and the investment term of the annuity itself. As an example, consider a five-year CD annuity whose 6% interest rate is guaranteed for five years and whose schedule of surrender charges for early withdrawals also extends for five years from the date of purchase. CD annuities have terms ranging from 1-10 years. Interest rates normally increase as the term lengthens; the current range is about 200 basis points.
CD annuities differ from the traditional fixed annuity, in which the initial credited interest rate is only guaranteed for as little as one year, with interest rates in succeeding years free to change each year in accordance with market conditions. (Bailout provisions often allow penalty-free escape from the fixed annuity if the renewal interest rate falls too far below the initial rate.) Another interesting point of difference is that a long surrender period is unambiguously detrimental with a traditional fixed annuity, while the long surrender period will be counterbalanced with a longer term and a (normally) higher fixed interest rate in the CD-annuity scenario.
CD Annuities vs. Bank CDs
The CD annuity superficially resembles a bank CD. Both instruments pay a fixed rate of interest for a fixed term. Both impose serious penalties for early withdrawal of principal. The term structures of the two assets overlap considerably, since bank CDs can have maturities of up to 5 years. The resemblance between the two is heightened by the fact that many people have treated bank CDs and annuities as highly substitutable investments, probably because of the high degree of protection for principal value embodied in both.
For investment purposes, however, the superficial resemblance between bank CDs and CD annuities is misleading. Bank CDs are best viewed as short-term parking places for money, with almost no liquidity. Their interest is taxable in the year of receipt. They are guaranteed, up to a limit of $100,000, by the FDIC. (The significance of this is at least as much political as economic. The FDIC’s assets are miniscule relative to their potential liabilities and it is really the implied promise of the federal government that stands behind the FDIC guarantee.)
CD annuities are fixed annuities. As such, they are best viewed as medium- to long-term fixed-income investments, with limited liquidity, guaranteed by the financial strength of their issuer. (As insurance products, they are also covered by state-level guarantees given by the associated insurance companies operating in the state.) Their scope for partial withdrawals gives them more liquidity than a bank CD. The annuity holder’s interest gains accrue tax-deferred, a substantial advantage over the gains from a bank CD. They can be rolled over without creating a taxable event by utilizing a 1035 exchange. Like other annuities, CD annuities are oriented toward retirement; the tax penalties for withdrawals prior to age 59 ½ and surrender charges clearly bias their incentive structure towards retirement finance.
CD annuities share a drawback with other fixed annuities, namely interest-rate risk. The very benefit of achieving a long-term guaranteed interest rate can turn against the investor when interest rates rise, implying that the investor is stranded with a lower return than could be achieved in alternative investments of equal risk. This tradeoff is endemic to fixed-income investing; the annuity holder must weigh the security of a fixed rate against the possibility of a future rise in rates.
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For Whom are CD Annuities Suitable?
The foregoing indicates that CD annuities are suitable for the same general class of investor that would consider a traditional fixed annuity. Their fixed-income and low-liquidity characteristics tend to exclude the youngest class of investors, while the latter tends to exclude the oldest. Middle-aged to late-middle-aged investors, particularly those reweighting their portfolios towards less risky investments, are the right age and risk class for CD annuities. The higher the current income of the investor, the more valuable is the tax deferral of a CD annuity.
There is a small degree of overlap between purchasers of bank CDs and CD annuities, centered around the shorter-term CD annuities and longer-term bank CDs. In general, however, it would be wrong to say that CD annuity buyers should be the same people who buy bank CDs. Mostly, buyers of the two instruments should be different ages, with different risk tolerances, different investment objectives and quite possibly different incomes and tax positions as well.
CD annuities are an intriguing variation on the fixed-annuity theme, in which the interest-guarantee period matches the investment and surrender-charge terms. The CD annuity’s principal difficulty is presented by its name, which encourages the investor to view it as a substitute for a bank CD. Although the two share certain superficial similarities, they are fundamentally different instruments suitable for different classes of investors.
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