Which investment choice is better? Annuities or CD’s? Both are similar investments because they are designed to be safe. But if you want the real truth to this question, you need to look a little deeper than what most financial experts tell you.
It seems that most financial celebrities despise annuities. (Financial Celebrities are the folks that have achieved some type of financial notoriety). They have TV or radio shows and travel across the Country telling people how to invest their money.
If you ever listen to them talk about annuities, they will say annuities are a rip off and every consumer should just stay away from them.
They will tell you that with an annuity you are locking up your money forever and the only people who benefit from them are the salespeople that sell them.
Then in the next breath, they will recommend you purchase a mutual fund and hold it for the long term, say 10 or 15 years. Huh? Why would this so-called financial expert recommend a product that can lose value and will be a roller coaster ride for the next 10 or 15 years?
There is no comparison between an annuity and a mutual fund –
Apples and Oranges
But comparing annuities to CD’s or Certificates of Deposit – safe investments – is much more accurate. Annuities and CD’s have much more in common but they also have some differences.
Annuities VS CD’s
Annuities – A little historical perspective may be helpful.
Annuities and CDs are similar in that they are safe, secure investments with guaranteed rate of returns based on interest rates, both are issued by large financial institutions, CDs are issued by banks and annuities are issued by insurance companies.
Annuities or Insurance is highly regulated by each state. This high level of regulation for safety’s sake was largely a result of the Armstrong Investigations of 1905, which was somewhat unflattering to the insurance industry. Intense creditworthiness from state regulation was the result.
Insurance companies must, by law, cover at least 100% of their liabilities with “reserves” – money set aside to pay claims in the case of default. Each state has their own reserve requirements required by The State Guarantee Fund. (check your State for protection limits).
There are also regulations as to the percentage that can be held in certain forms of assets. Most insurance companies hold a very large portfolio of government bonds for safety. The system has produced a remarkably overall record for safety and solvency.
Insurance company reserve requirements are much more stringent than CD’s. But even with all the protection that the State Guaranty fund provides, you still need to be a prudent consumer and look for an insurance company with a good financial ratings.
CD’s and The Federal Deposit Insurance Corporation
CD’s are backed by the FDIC, Federal Deposit Insurance Corporation. FDIC is sworn to pay depositors, upon the default of a bank, up to $250,000.
FDIC is normally funded by the banks themselves. (It is an assessment fee to member banks.) But more recently, taxpayers have been asked to pony up bail out money too due to higher bank defaults over the past several years.
All of this history is merely to point out that banking, by its very nature, has some risk too as we have seen in the recent past.
What About Taxes?
You will pay income taxes on CD interest earned each year. Earnings are paid out each year and state and federal taxes need to be declared on your income tax return.
Annuity interest is tax-deferred so you won’t pay any income tax until you withdraw funds or cancel your annuity. So with annuities the deferred tax on your interest remains in the investment earning you more money, instead of being paid out to state and federal tax agencies on a yearly basis.
Access To Your Money
CD’s do not allow you to withdraw funds during term. If you cancel your CD you will have to pay a penalty at most banks.
If you cancel your annuity before the end of the term, you will suffer a surrender fee imposed by the insurance company.
If you are under age 59 1/2 and you cancel your annuity, you will have to pay taxes on any gains plus a 10% penalty imposed by the IRS.
Annuities have liquidity provisions that allow you to withdraw money which most CD’s do not. Most annuity contracts allow you to withdraw 10% of your account value each year without any penalty.
Another added benefit of annuities is that they allow you access to all of your funds and waive all fees in the event you are hospitalized, undergoing a life-threatening illness, are subjected to a permanent or extended stay in a nursing home and other major calamities that affect you economically.
In addition, annuities can be structured to pay a monthly income (annuitize) to the owner over a fixed term such as 5, 10, 20 years or more. This annuitization helps spread out your tax-burden and provides enhanced income security during retirement. In short, Annuities offer enhanced flexibility.
Historically Higher Returns:
Annuities have historically returned higher returns than CD’s. You would be lucky nowadays to find a 5 year CD yielding more than 2%. On the other hand, many annuities are currently paying 3% or more depending on the length of term you purchase.
Annuities also have a minimum interest rate guarantee, usually 2% or 3%. So even if interests rates go down, your investment will never fall below the guaranteed minimum rate.
I hope this comparison has helped clear up some confusion about the “bad rap” that many people give annuities. They are just another way to invest your money. Just like any investment vehicle, annuities are right for some people and wrong for others.