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Fixed Annuities vs CDs: Which is Right for You?

For those seeking a low-risk investment with safety of principal, fixed annuities and CDs are both appropriate options. When choosing between the two, however, you should take into consideration the benefits of each individually, relative to your unique needs.

Let’s start with the basics for each option:

  • Fixed annuities are issued by life insurance companies and are typically used as a tool for retirement savings. They have profiles similar to a traditional pension plan.
  • Certificates of deposit (CDs) are typically issued by banks and pay a contractual rate of return, typically ranging from 3 months to as long as 5 years.

While fixed annuities and CDs have many similarities, meaningful differences include:

  • How they fit within different investment objectives
  • Length of commitment
  • Tax treatment
  • Where they are sold

How do investors use them?

Both products provide safety and comfort in exchange for modest, low-risk returns. The difference lies in when those funds might be needed, and for what.

For example, long-term investors saving for retirement may consider fixed annuities, especially if they have maxed out their 401K and/or IRA contributions.

On the other hand, traditional CDs are a reliable vehicle to house money for the short to medium term. Investors can use them to store funds ahead of a foreseeable need:

  • Down payment on a home
  • College expenses

What are tradeoffs between fixed annuities and CDs?

The pension-like features of fixed annuities include tax deferral and the option to receive guaranteed income for life. Interest is accumulated on a tax-deferred basis over a period of years. At termination, there are several ways to receive back your principal and accumulated interest. This ranges from a lump-sum payment to variations of guaranteed income, either for a fixed period or for life.[1]

It’s worth bearing in mind that fixed annuities bear higher penalties for early termination (“surrender charges”) and a 10% IRS penalty for withdrawals before the age of 59 ½.

CDs[2], by contrast, are arguably one of the safest investments available to consumers. They also offer more flexibility and fewer liquidity constraints than fixed annuities. However, in exchange for that safety and flexibility, returns are also generally lower.

Differences in Tax Treatment

Interest earned on a fixed annuity is treated on a tax-deferred basis. The tradeoff is that assets invested into a fixed annuity should generally be committed for the long haul.

Interest earned on a CD is taxed immediately at the end of the year it is paid. That means that even if you have a multi-year CD where interest is not paid to you until some distant future date, you will incur a negative cash flow in order to pay your current year taxes.


Where are fixed annuities and CDs sold?

Fixed Annuities

  • Insurance agents
  • Brokers
  • Insurance-licensed bankers

CDs

  • Banks
  • Brokers

What are the inherent risks of these products?:

  • Credit – The risk that the insurer or bank will be unable to repay the money owed to you. These are rare events, and regulators go to great lengths to hold banks and insurers to high solvency standards. In the event the issuer defaults, however, FDIC protects most CDs and State Guaranty Associations add a layer of protection for annuities (more on that later).
  • Inflation – The risk that your money will not grow as fast as prices are rising.
  • Interest rate – Interest rates fluctuate over time. This can create variability in your future interest revenue, except when a rate is guaranteed at minimum or specific level.
  • Liquidity – Money invested in either product is expected to be for the contractual term. The level of the interest you receive reflects that. Early withdrawals that exceed contractual maximums are almost always subject to penalties. In the case of fixed annuities, that may include an IRS penalty on top of surrender charges.

What happens if a bank or insurer goes bankrupt?

Most CDs benefit from the same FDIC protections afforded to checking and savings accounts. As an individual, your money is protected up to $250,000. When considering the purchase of a specific CD, the applicability, nature, and scope of this guarantee should be confirmed and clarified with your agent or banker.

Insurance products, including fixed annuities, are regulated on a state-level basis. Each state has its own guaranty association. The levels and types of protection provided vary widely from one state to the next. While this is a very important backstop, it should not be viewed as equivalent to FDIC protection.

In many states, insurance agents are not permitted to mention guaranty associations as a selling point. This is a good business practice. Choosing an insurer with stable financial strength should be one of the primary goals of the fixed annuity purchasing process.


The Breakdown

Fixed annuities and CDs are both useful money management tools. Each has its distinct use case. The safety, flexibility and shorter term commitment of CDs gives them good utility, in spite of their tax inefficiencies. For a longer time horizon, the tax-deferral and income-for-life options available via fixed annuities are valuable features, especially as part of a broader retirement plan.

Before choosing your best option, it pays to do your homework. You can get up to speed online or with a traditional agent or advisor. As always, be alert to the biases and preferences of your information source. Most sources you will encounter are paid for selling a specific product rather than providing advice. That is simply the way of the world. If what you hear sounds like a sales pitch, it probably is.

At ALEX.fyi, we are looking to challenge that model. Let us know if there are questions about annuities that aren’t being answered for you elsewhere! We’ll be happy to answer them.


[1] Income for life options are either available with or inherent in other forms of annuity, including variable, fixed index and immediate. These are outside the scope of this post.

[2] I am referring to Traditional CDs, paying a fixed rate of interest and guaranteed by the FDIC. There are now more complex CDs available, which carry different elements of risk that we will not address here.

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