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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.

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"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 the investment.

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.

Withdrawal provisions
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 leeway.

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 gains.

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 accounts.

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 annuity.

"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.


-- Posted: Oct. 29, 2002



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