My father, who is 75, recently had a CD that matured for about $50,000, and the question is what to do with the money. My dad doesn’t need the money, and he is very conservative when it comes to investing. I wanted my dad to consider a group of stock mutual funds, but he doesn’t feel comfortable going that way. His bank recommended a fixed annuity that would pay him a guaranteed rate of return of three percent for the next five years. The bank also quoted him a rate on a five-year CD that was close to what the annuity is paying. He is either going to do the CD or the annuity, and I want to help him make the decision. Can you tell me what you think the pros and cons of each of these investments are?
In reviewing the pros and cons of each of the aforementioned investments, there are some similarities between the two. First, in a fixed annuity and a CD, you get a guaranteed rate of return and your principal is guaranteed. In addition, in both investments, because your return is guaranteed, no matter what happens in the market or the economy your principal cannot go down.
Fixed annuities and CDs also share the same negative, and that is their return. Although annuities and CDs are marketed as risk free, that is not the case. Returns on CDs and fixed annuities are relatively low, and the risk that you take is known as purchasing power risk. In other words, the returns don’t keep up with your increased cost of living. Yes, at the end of the period of the annuity or the CD you have more money; however, that money doesn’t buy as much as it used to; that is purchasing power risk.
One of the pros of fixed annuities that differentiates them from CDs is the fact that the interest earned grows tax deferred. You only pay taxes when you withdraw the income earned. Particularly for seniors, the tax deferral can have another benefit and that is, because your income is deferred, it won’t impact the cost of your Medicare B premium. The Medicare B premium is based upon income, and if you let your annuity reinvest and grow, there’s no income that would impact your Medicare B premium. The savings on your Medicare B premium can be substantial.
The major downside of the annuity is that it is not as flexible as a CD. Fixed annuities have penalties that are substantially higher than in a CD. Typically in a CD, if you close it out before maturity, you pay a penalty, but it’s generally relatively minor- such as losing one calendar quarter of interest. On the other hand, in a fixed annuity, penalties are substantially higher. For example, if you were going into a five year annuity and you closed out after three years, you could be on the hook for a 5% penalty. That 5% penalty is on the entire account balance not just on the interest earned.
The main benefit that a CD would offer you over a fixed annuity is flexibility. As I mentioned, the penalties on early termination of CDs is relatively minor. Therefore, if for whatever reason, you needed to close out the CD before maturity, you would not suffer nearly the penalty as you would in an annuity. On the other hand, the downside of CDs is that the interest you receive is currently taxed to you. Unlike in the annuity there is no deferral in CDs.
In choosing between the two, obviously the return is important. However, equally as important is the time period you are going to commit the money to. If you know that you can leave the money until there is no penalty, the annuity may work for you. However, if you’re uncertain that you can commit the money for the full period of time, then the CD is the way to go.
One last note regarding annuities and CDs is that you should shop them around. You would be surprised how different the rates are. In addition, in a CD or annuity, I would not go longer than five years. Interest rates are on the rise and as far as I’m concerned it doesn’t make sense to lock up for more than five years.
If you would like Rick to respond to your questions, please email Rick at firstname.lastname@example.org.