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CDs Vs. Annuities: Where Should Clients Invest Their Money?

CDs Vs. Annuities: Where Should Clients Invest Their Money?

Many seniors near or approaching retirement today are on the fence when it comes to investing in CDs or annuities. As advisors, we know that these are two very different animals, and it is our job to explain the various differences to our clients.

In a client’s eyes, annuities and CDs might appear to be very similar at first glance. Both are secure, low-risk investments that are designed to help the client accumulate wealth. However, it’s important to explain to clients that these two types of investments have several contrasting components.

First of all, some clients may not know that CDs are generally issued by banks while annuities are only offered by insurance companies. Secondly, your client may not realize that a CD is typically a better investment for short-term goals, such as a down payment on a new home or car, while an annuity is a better choice for longer term goals, like generating a lifetime stream of retirement income.

Here are a few things to keep in mind as you work with your clients to determine which vehicle will be the best investment option for them:

CD Real Returns are Often Negative

Interest rates have plummeted in recent months, while inflation, led by food and fuel prices, is heating up.  While clients purchasing a home can reap the benefits of these low interest rates, they may not realize that this also translates into lower returns on bank investments. Right now, one-year CDs often pay 1.5 percent or less—a huge drop from a couple of years ago when CDs often paid more than 3 percent. In addition, whether the CD holder withdraws the interest earned or lets it accumulate, they are still taxed on the interest earnings at the end of each year. Add the cost of inflation into this return and most CDs actually provide a negative yield.

The future is uncertain for CD interest rates. Because it is impossible to predict, a CD earning a very competitive rate today may renew at a ridiculously low rate in one year from now. For those clients who need to maintain a certain retirement income level, a CD may not be the right answer.

Fixed and Variable Annuities

Because there are so many different types of annuities, it’s no easy task to compare these investments to CDs. The two categories of annuities are variable annuities and fixed annuities. And within these categories, there are many subcategories.

It’s important to explain to clients that variable annuities are basically mutual funds wrapped in an insurance policy issued by an insurance company. These annuities are tax-deferred like all annuities, but they are at a higher risk than fixed annuities because their performances are tied to the performance of the stock market.

Conversely, fixed annuities offer a guaranteed minimum rate of return. This ensures that your client’s investment will not drop below the minimum declared rate. When interest rates drop, so do returns on CDs. But fixed annuity returns never fall below a certain point. Therefore, if a fixed annuity is held until maturity, the policy owner is guaranteed to earn a minimum stated rate of interest regardless of what to interest rates or stock market indexes. Because fixed annuities are no risk, conservative investments, they are often ideal for retirees or soon-to-be retirees.

Fixed annuities offer incredible tax advantages
With CDs, a certificate holder must pay taxes on the interest earned even if they haven’t withdrawn any money from the investment. Alternatively, fixed annuity earnings are tax-deferred. While there is a set annuity withdrawal term, annuity owners only pay taxes on interest earned when they withdraw money from the annuity. This means your client ends up earning an increasing amount of money with fixed annuities because the deferred tax on their interest remains in the investment instead of being paid out to state and federal taxes each year. The overall effect is called triple compounding:  interest on the principal, interest on the interest, and interest on the taxes that would be taken out of the interest.

CDs aren’t as flexible
You should advise your clients that fixed annuities also offer more flexibility than CDs. With a CD, the client cannot withdraw funds prior to the end of the term without incurring an early withdrawal penalty. Although fixed annuities also have early withdrawal penalties known as surrender charges, they include provisions that typically allow a policy holder to withdraw 10 percent of their account value each year penalty free. Additionally, many fixed annuities allow for interest only withdrawals within days of the contract being issued.

Some fixed annuities also have no cost riders that allow your client to access a portion or all of their account with no fees in the event of a qualifying condition, such as terminal illness. If a client is diagnosed with an illness that has a life expectancy of 12 months or less, their entire account can become liquid and penalty free. Another qualifying event is requiring long term care or being confined to a hospital or qualified institution for a period of usually no less than 60 days.

Annuities also offer annuitization options, which allow your client to receive a guaranteed amount of income for a period of time. Annuity payout options can be structured to pay for a policy holder’s entire life, or for a period certain as little as five years.

Annuities are Safe
It’s important to remind your clients that annuities are extremely safe because they are issued by insurance companies. As compared to banks and brokerage firms, insurance companies have a historical record of stability. This is largely because insurance companies are allowed to use much less leverage than banks are, and must keep substantial reserves, as compared to other financial institutions. They also typically match assets and projected revenues to anticipated liabilities, rather than structure themselves to maximize flashy short-term returns at the expense of the volatility of the insurance portfolio.

Point to the History
Looking back, we know that insurance companies have survived times of war, global depressions, government failures, industry scandals and disastrous stock market plunges. However, in even the worst of times, Americans have been able to safely insure their homes, health, life, cars and businesses. In fact, the insurance industry is what led our country out of the Great Depression.

Also, explain to your clients that each investment product offered by an insurance company must be approved by the state Insurance Commissioner. Some states have a Guaranty Fund that further protects a client; however this should never be discussed for the purpose of soliciting business. Some states completely forbid licensed agents from talking about any details pertaining to their state’s Guarantee Fund even if the client brings up the topic. If you violate these rules, it can result in fines, penalties and possible loss of license. Be sure you fully understand what you can and cannot discuss with regard to your state’s Guaranty Fund.

Survey says…
All things considered, fixed annuities play a key role in safe retirement planning for your senior clients today. These superior, reliable investments can provide higher returns, tax advantages and enhanced flexibility, all while providing safety and security. And as if that’ not enough, they can give your clients peace of mind knowing that they can never outlive the income provided by a fixed annuity.

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