Indexed CDs offer safety, but there's still risk
|By Suzanna de Baca Bankrate.com
With the global economy still on uncertain footing,
consumers are on the lookout for investments that limit downside
One such product is an indexed CD, or ICD, a hybrid that couples the principal protection of a plain vanilla certificate of deposit with the upside promise of the equity markets.
"The average consumer will be hearing a lot more
about these instruments if the markets stays volatile," says Karin
Maloney Stifler, president of True Wealth Advisors in Hudson, Ohio.
Despite the fact that indexed CDs have Federal Deposit Insurance Corp., or FDIC, protection, she cautions that "consumers hear 'FDIC' and assume safety, but it is not the same as a regular CD."
How do indexed CDs work?
"An investor in equities is directly subject to the volatility of the marketplace and is at risk for loss of principal," says Michael T. Sherzan, president of Bankers Financial Services Corp. in Johnston, Iowa, a major provider of indexed CDs to banks nationwide. With ICDs, he says, "the depositor not only has an investment that is principal protected but also has the potential return of the corresponding index."
Unlike their conventional CD cousins, indexed CDs offer investors exposure to a specific equity index such as the Standard & Poor's 500 or the Dow Jones industrial average. Still not widely available, indexed CDs are sold primarily by community banks in a variety of maturities, typically in the three- to five-year range. Minimums are generally $1,000, with additional investment available in increments of $1,000. If the indexed CD is held to maturity, the principal and earned interest is guaranteed up to $100,000 per taxable account, or $250,000 for retirement accounts, in accordance with FDIC rules and regulations.
Joe DiNuzzo, counsel to the FDIC, notes that while principal up to the FDIC limits is insured, interest income must be considered separately. "If the interest is based on an outside factor like an index," he says, "then it depends on how each bank credits that interest."
While the terms vary, indexed CDs typically pay interest at maturity; some guarantee a set rate of interest even if the market does not rise, and other issues offer only the returns of the linked index, and that performance may be capped.