The pros and cons of CD-type annuities
Investors are on a seemingly endless quest for a safe haven for
their fixed-income dollars, preferably one with a better return
than the certificate of deposit offerings at the corner bank.
When it comes to CDs, there's a horse of a different
color out there; it's called a CD-type annuity. They sometimes offer
better rates and helpful tax advantages, but they are also much
harder to get out of, and they are not protected by the Federal
Deposit Insurance Corp.
Some experts advise against CD-type annuities because
of the interest costs and IRS penalties involved in getting out.
If rates go up, you're locked in at a lower rate.
CD-type annuities are fixed-rate annuities. They're
different from most fixed annuities in that the guaranteed rate
matches the penalty period. In other words, if you buy a five-year
CD-type annuity at 4 percent, you're guaranteed to get 4 percent
annually if you hold the CD for five years.
Other fixed rate annuities have no maturity date and
often guarantee a rate only for the first year. The interest rate
usually drops after the guaranteed period and is adjusted annually.
Those annuities tend to have a bad reputation, even among people
in the insurance industry -- the only people licensed to sell annuities.
"We only sell CD-type annuities. What you see
is what you get," says Danny Fisher, president of Fisher Annuity
Index in Dallas. "There are a lot of annuities in the marketplace
that have snakes in the woodpile. People don't want to trust the
insurance company to tie up their money and be fair with them. That
hasn't worked well in the past."
The CD-type annuity was developed to solve the problem
of insurers making empty promises to continue paying a high rate
after the guaranteed period. Rates were falling and customers weren't
getting what they expected, so they paid a penalty to get out of
But does that mean CD-type annuities are safer or
smarter investments than a CD that you'd buy from a bank? Let's
look at some of the major differences.
"People are coming to us because they have
a CD at the bank that was earning 7 percent and now they're being
offered 2.5 percent," Fisher says.
Typically, CD-type annuities offer about a 1 percentage
point advantage over certificates of deposit. Click
here to see current CD rates.
Bank CDs are not tax-deferred investments unless they're held in
a tax-deferred account.
CD-type annuities are tax-deferred investments, but
if you cash your five-year CD before age 59½, you'll pay
the IRS a 10 percent penalty on the gain.
Early withdrawal penalties
With few exceptions, you'll pay a penalty if you cash a bank CD
or a CD-type annuity before it matures. You'll often forfeit three
months' interest on bank CDs of less than one-year maturity or six
months' interest on CDs that mature in one year or more.
Fisher says the surrender charges on CD-type annuities
start, on average, at 8 percent in the first year and decreases
1 percent a year after that. Cash a five-year CD in the first year
and you'll pay 8 percent; cash it the second year and you'll pay
7 percent, etc. And, if you're under 59½, you'll pay that
10 percent penalty to the IRS.
Many bank CDs don't allow you to make partial withdrawals, but banks
are becoming more creative with CDs, and a growing number of them
are offering "no-penalty" CDs that give customers some
Many CD-type annuity contracts allow customers to
take out up to 10 percent of the balance or up to 100 percent of
the interest annually without insurance company penalties. The IRS,
however, is not that generous. You'll pay a 10 percent penalty on
The FDIC covers CDs held in your bank or brokerage
account. If your bank or brokerage fails, FDIC coverage
will reimburse you up to a maximum of $100,000 per
non-retirement account or $250,000 for retirement
If your insurance company fails, your CD-type annuities
might be covered up to $100,000 by your state's guaranty association.
The associations operate under their state law. What they cover
and how much varies from state to state.
If you're considering a CD-type annuity, you'll have
to ask specifically about what is covered by the state guaranty
association. Most states do not allow insurance agents to mention
the coverage as a selling point.
Certified financial planner and registered employee
benefits consultant Michael Miles of McLean, Va., says he's leery
of CD-type annuities as an investment.
"The tax deferral is interesting, but I can't
really see where that overcomes the limitations of an annuity contract.
These things tend to be marketed to people who are chasing an interest
rate," says Miles. "As a financial planner, my intention
in annuities is to solve a functional need; guarantee income over
someone's lifetime, prevent the depletion of a source of money vs.,
'Wow, that sounds like a great interest rate.'"
Investors who opt for a CD-type annuity should get
everything in writing, says CFP Jay Shein of Compass Financial Group
in Lighthouse Point, Fla.
"There's no free lunch. Ask how fast I can get
out, what are the penalties -- both IRS and the insurance company.
Ask what the commission is and have them put it in writing. You
should know what the conflicts of interest are. The fact that they
exist is OK, but you need to know what they are."
Danny Fisher disagrees that information about the
commission is important.
"What does it matter to the client? He's buying
a guaranteed rate regardless of what the commission is. It doesn't
matter what's in the deal for the agent because the client has a
guaranteed deal. The only question for the customer is, should it
be for four years or five years, and who's got the best interest
rate?" Fisher says.
But CFP Benjamin Tobias of Tobias Financial Advisors
in Plantation, Fla., says you have a right to know why someone you're
going to for investment advice is promoting a particular product.
Knowing how much commission the agent makes can open your eyes.
Tobias also questions the value of locking in a low
rate with the typical early withdrawal penalty structure of a CD-type
"Let's say we have a five-year CD-type annuity
at 4 percent and let's say the average five-year rate in 2005 is
8 percent. Now suppose three years down the road you want to get
your money out. You're looking at 5 percent cost. You're locking
in a low rate. There's no logic to locking in rates when they're
low and we don't know when they'll start turning up."
Fisher says most CD-type annuities have an escape
hatch. The penalty will be waived if the customer allows the insurance
company to pay them over a five-year period or longer.
That may not sound like much of a deal to someone
who is cashing out because they want their money right away, but
it might work for some people.
CD-type annuities are probably best for people who
are close to age 59½. You'd want the annuity to mature after
you're 59½. Otherwise you'll have to roll over the annuity
to avoid the 10 percent IRS penalty.