Fixed annuities or CDs: Retirees have a big decision to make as interest rates fall
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No one wants to run out of money in retirement.
If you’re hoping to have enough savings to live off into your 70s, 80s and even 90s, you’ll need to plan ahead. You must also carefully consider where you’ll store the funds you’re setting aside to provide a sufficient income stream in retirement. Sometimes that can be more difficult than saving the money itself.
One decision that can be tough for retirees is choosing between certificates of deposit (CDs) and fixed annuities. Conservative investors may feel secure knowing that CDs are insured by the federal government, but there are tax incentives associated with the annuities that insurance companies offer.
Fixed annuities vs. CDs: Rates
CD rates have stalled for months, and yields across the board have been falling more recently in anticipation of a decision to cut interest rates at the Federal Reserve meeting on July 31. As expected, the Fed lowered its key borrowing rate 0.25 percent to a range of 2 to 2.25 percent. It was the central bank’s first rate cut since the financial crisis in 2008.
Long-term CDs, in particular, have taken a hit. In just a few months, the average five-year CD rate fell from 1.48 percent APY to 1.29 percent APY, according to Bankrate data. Even though the Federal Reserve has held the fed funds rate steady for half the year, CD rates have fallen as Treasury yields have declined.
The Fed’s decisions may have little to no impact on annuity rates, depending on the kind of annuity you’re interested in. Rates on fixed annuities, however, will likely drop.
Historically, annuity rates have been higher than CD rates found at the bank, says Bryan Bibbo, an adviser at the JL Smith Group in Avon, Ohio. With a fixed five-year annuity, for example, it’s possible to end up with a rate of 4 percent. Today’s best five-year CDs pay just over 3 percent APY.
Fixed annuities vs. CDs: Security
CDs and fixed annuities are similar because in the end, you’re guaranteed to receive your principal investment plus a certain amount of interest. But they’re insured by different entities.
Fixed annuities are insured by insurance companies, which aren’t always financially secure or creditworthy. If an insurer goes bankrupt, another will likely step in. Annuity holders will get some sort of minimum guaranteed payout, but their interest rate will be reduced, according to Bibbo.
Bibbo recommends reviewing insurers using data from two or three credit agencies and finding out how financially sound a particular company is before funding an annuity.
Craig Kirsner, a retirement planner and an investment adviser representative at Stuart Estate Planning Wealth Advisors, says that few insurance companies ever fail. But his clients have peace of mind knowing they’re getting an annuity from an A-rated insurer.
Some banking institutions are healthier than others from a financial standpoint, so comparing how safe and sound banks and credit unions are could be a good idea. Unlike annuities, however, CDs, are generally insured up to $250,000 through the Federal Deposit Insurance Corp. or the National Credit Union Share Insurance Fund.
With fixed-indexed annuities, your principal investment is protected and there’s an opportunity to potentially earn more interest than you would through a standard fixed annuity. But because returns depend on the performance of market indexes like the S&P 500, you could end up earning no interest at all in a single year.
Fixed annuities vs. CDs: Taxation
The guaranteed rate of return is nice for savers with CDs, but they pay the price when tax time rolls around.
If you have a CD, expect to pay taxes on any interest you earn every year, even if you don’t have access to that money. With annuities, however, your money grows on a tax-deferred basis and you won’t owe any taxes until you’re ready to make a withdrawal.
“If you’re in a higher tax bracket and don’t need the money for some time, you’ll enjoy the power of tax-deferred compounding inside an annuity,” says Kelly Crane, chief investment officer of Napa Valley Wealth Management.
Fixed annuities vs. CDs: Penalties
CDs come in different flavors and some, like no-penalty CDs, don’t hit you with a penalty for withdrawing your money before the term ends. But with traditional CDs, there is an early withdrawal penalty that varies depending on the length of the term and the bank or credit union managing the account.
With most annuities, you can withdraw a portion of the fund (usually up to 10 percent) per year without incurring a penalty. But for fixed annuities, fees in the form of surrender charges often come into play, and you’ll be charged for pulling out funds within a certain time frame after investing in an annuity. You could easily end up with a penalty just by not understanding the terms of your contract, Bibbo says.
Making the decision
Retirees have a lot to consider before deciding how to invest their money.
Annuities offer many benefits, particularly as CD rates decline, but individuals must consider their time horizon, financial plan and whether going with an annuity makes sense. Doing plenty of research and comparing CD rates is key.