Bank certificates of deposit, or CDs, and annuities are two popular and safe investment options that can provide a steady income stream for investors.
Both have advantages and disadvantages that depend on a client’s financial goals, time horizon, and risk tolerance.
Rising interest rates have suddenly made both types of products much more attractive.
Here’s a look at how the products work, along with the typical profiles of clients who tend to benefit the most from each type of product.
CDs Basics
CDs are deposit accounts offered by banks. They have a fixed interest rate and a fixed “term,” or length of time that the account lasts.
When the term ends, your client receives the original deposit plus the interest earned.
CDs typically offer higher interest rates than regular savings accounts.
They’re FDIC-insured, making them one of the safest places for your clients to put their money.
The main downside of CDs is the lack of flexibility; withdrawing funds before the maturity date results in penalties.
Also, the returns, though guaranteed, may not outpace inflation.
CDs are ideal for conservative investors seeking a low-risk way to grow their savings over a specific period.
Annuity Basics
Annuities are insurance products that pay out income based on an investment the client made with an insurance company.
Annuities are designed to provide a steady income during retirement. They offer a guaranteed income stream for life or a specified period.
A life annuity can provide a hedge against clients outliving their income.
Some policies also offer potential for growth linked to the performance of investment markets or bonds. These products can be riskier than other annuities, but clients are guaranteed a minimum payment.
Annuities can be complex, with high fees and surrender charges for clients who withdraw funds early.
Riders can eat away at clients’ annuity earnings, without providing useful benefits in returns, if clients are not careful about picking only the riders they need.
Annuities are best for clients who are further along in their retirement planning.
They require a long-time commitment, so they’re not well-suited to younger investors who are still unsure about what they want their retirement to be.
The Choice
One factor is how the client balances the desire to maximize returns with the need to minimize risk.
While CDs and annuities can both offer fixed returns, fixed annuities’ minimum returns tend to be higher, because the money an annuity earns is more than just interest and includes things like bond returns.
Variable annuity returns are based partly on market performance and can provide a bigger upside than CDs or fixed annuities, though there may be some downside risk, as well.
A second factor is federal income taxes.
Interest from CDs held outside retirement accounts is taxable in the year it’s earned, while annuity earnings are tax-deferred until withdrawal.
A third factor is the nature of a client’s plans for the future.
CDs generally require a term length of just a few months to a few years. That makes them a great place to park a client’s money if the client is not sure what else to do.
Annuities are typically less flexible, because the accumulation phase (the period when the client pays in money) can last for decades.
Both CDs and annuities levy penalties for early withdrawals. However, annuity surrender charges can be more substantial.
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