Anytime a question is poses as “are XYZs better than ABCs?” it invites controversy especially when it involves a comparison of “apples and oranges”. No one will argue against the notion that annuities, or, for that matter, any particular investment vehicle, aren’t for everybody. This presupposes, using the same rationale in reverse that CDs are also not for everybody. The only way the question can be answered meaningfully is when is posed in the context of any one person’s personal financial situation. Only with a good understanding of your own financial objective, needs, priorities and tolerance for risk, can you address the question of “Are annuities better than CDs.”
Comparing the Two as Apples
Let’s first examine the characteristics that are somewhat “apples to apples”:
Certificates of Deposit (CD)
CDs are a bank savings instrument structured as timed deposits which pays a fixed rate of interest over a set period of time. The length of maturity terms varies between months and years, the shortest being three months and the longest being 5 years. Minimum deposits can be as low as $500 for a short term CD and as high as $10,000 for a “jumbo” CD. Smaller CDs with shorter maturity periods are credited with the smallest interest rates. Conversely, the larger CDs, such as jumbo CDs, with longer maturities earn a higher rate. If you want to withdraw your money before the maturity date, you will be charged a penalty which typically comes in the form of a reduced interest rate credit on the entire balance. The interest earned on CDs is taxed as ordinary income. When a CD matures, it can be renewed for another term.
CDs are issued by commercial banks, and if the issuing bank is member of Federal Deposit Insurance Corp (FDIC), its deposits, up to $250,000 per depositor, per bank, is protected against default. Deposits on account with a bank are generally used in the bank’s lending business. Essentially, your CD deposit is loaned out to bank clients or to other banks. The Federal Reserve only requires that banks keep a small fraction of the deposits on reserve because the Federal Reserve system will ensure their liquidity.
Annuities are a form of an insurance contract issued by a life insurance company. In exchange for a deposit of money by an investor, the insurer guarantees either a minimum savings accumulation or a minimum income for a specified period of time. The initial interest yield is guaranteed for a specified term of one year to 10 years, and is adjusted when the term expires. The contract does include a minimum rate guarantee that acts as a floor should interest rates drop below it. Longer term annuities can earn higher initial rates and there are also deposit breakpoints which pay a bonus rate for larger deposits.
Annuities do allow for access to funds. Investors can withdraw funds once annually, but funds withdrawn in excess of 10% of the account value will be charged a surrender fee of up to 10%. The surrender fee is reduced annually until it reached zero after which any amount may be withdrawn. Accumulated earnings are not currently taxed until they are withdrawn. And, if withdrawals are taken prior to age 59 ½ the IRS may assess a 10% penalty unless certain conditions are met.
Annuities are also considered to be among the safest of savings vehicles. The life insurance industry is considered to be the strongest and most financial stable of all financial institutions. The very strict reserve requirements for life insurers ensure that there is sufficient liquidity to meet their obligations. Although insurer deposits are not insured by the FDIC, each state maintains a guaranty fund that acts in much the same way. But unlike the FDIC which only maintains a small fraction of reserves to cover defaults, the guaranty funds are fully funded.
Comparison Based on Investment Need or Preferences
When comparing the two against specific investment needs or preferences, the distinction between the two become clearer.
Prefer the Most Competitive Rates
In both cases, interest yields are based on prevailing short term interest rates. Bank CD rates are generally derived from the prevailing market and also sensitive to short term movements in the rate. Life insurers derive the interest yield on annuities from the yield generated on its investment portfolio. Because the portfolios to invest in a range of long, medium and short term bonds, the yield tends to be higher than those of bank CDs and they are not quite as sensitive to short term rates. Overall, annuities tend to have more competitive interest rates.
Prefer Tax Advantaged Growth
Bank CD interest earnings are fully taxable as ordinary income. Earnings inside of an annuity are taxed until they are withdrawn.
Both are extremely safe and provide investors with layers of protection. The recent failure of hundreds of banks during the economic crisis as compared with zero failures of life insurers during that same time points to the vulnerability of the banking system. Some economic experts have expressed concern over the ability of the Federal Reserve system to withstand another big economic crisis. And, the FDIC is, essentially, broke. Historically, the life insurance industry has always fared better during difficult economic times.
Flexibility and Access to Funds
Both CDs and annuities offer access to funds but with penalties attached prior to their maturity. CDs must be held to maturity in order to receive the full amount of interest credited. Early withdrawals can result in the loss of six months of interest. Annuity funds may be accessed once annually, free of penalties as long as the amount doesn’t exceed 10% of the account value. If you place $100,000 in a CD you can’t just access a part of it – the whole certificate would have to be redeemed. With an annuity you can withdraw $10,000 without penalty and without having to surrender the contract.
The same test applying a different set of investment needs or preferences might produce an analysis more in favor of bank CDs. It really comes down to what’s important in your financial situation. Before making any similar comparison between any two investment products, make sure that it is done in light of your specific investment profile.