Once, when a customer entered a bank looking for a way to grow his money he was offered one product: A government-insured bank account. Regardless of whether the account was a checking account, savings account, or certificate of deposit, the contract between the customer and the bank was clear; “I give you my money to hold. You keep it safe until I take it out, and possibly add a small amount of interest.
Not so today. Many banks offer an array of non-traditional products that do not honor this implicit guarantee. Many of the customer service representatives are just as likely to offer mutual funds, insurance products and brokerage accounts as traditional bank accounts.
It is common for a representative to hold multiple licenses to sell insurance and securities, but this freedom of choice is not always in the depositor’s best interests.
This article is written after a disturbing experience with the new realities of banks operating in a low-interest environment where disappointed customers are desperate to see some return on their dollars.
The author spoke to a customer service representative about opening a certificate of deposit, but was pitched an annuity. Shortly after, a good friend, looking for a certificate of deposit had the same thing happen. Fortunately, he investigated before biting. Although annuities can be valuable, they are not replacements for Certificates of Deposits and encouraging customers to think they are is a form of fraud.
Certificates of Deposit or CDs are a very different animal from an annuity. CDs, also known as Time Deposits, are an account where a depositor agrees to keep money in the bank for a specific period of time in exchange for a somewhat higher interest rate than he might receive in a passbook account, money market savings account or checking account.
All CD’s are government insured up to a certain limit to protect the depositor from bank failure. Typically, the depositor can cash in a CD early if he is willing to forfeit some interest and pay a penalty.
Except for out-sized CDs with deposits in excess of the government insurance limit, these accounts are largely risk-free. The worst thing that can happen is if the bank fails, the depositor will find that he no longer receives the expected interest rate and is given his funds back early. The interest rate that the depositor receives is disclosed at the start and the depositor will get every dime of his original investment handed back to him at maturity.
Annuities are insurance. They are not guaranteed by the government and their safety rests with the strength of the insurance company that issues it. Perhaps you are familiar with life insurance. When people buy life insurance, they are protecting against the possibility that the person who buys the policy will die young. Life insurance is very important when raising children who must be provided for if one or both parents die.
Think of an annuity as reverse-life insurance. Instead of protecting against the danger that a person will die too young, they protect against the possibility that the insured will outlive his money. There are many types of annuities, but they have one thing in common: In exchange for giving the insurance company a sum of money, the company guarantees to pay a regular check to the investor. Think of this as something like social security or the old-fashioned type of pension that pop or grand-pop had. You fund it and then the insurance company starts sending checks.
Many people need this. Perhaps you have been injured on the job and Workers Compensation tells you that they will send you a check each month until the day you die. An annuity makes this happen. Maybe you have heard of a lottery-winner who receives a check a month every year for the next 20 years. An annuity makes this possible too.
Used correctly, an annuity is a valuable tool, but when a bank employee suggests that annuities and CDs are interchangeable, he is not acting in a depositor’s best interest. CD returns can look paltry compared to the rich returns on an annuity, but there is a good reason for this: part of the return of an annuity comes from the purchaser’s own money.
If I told you that if you gave me ten thousand dollars for ten years and in return you would receive ten percent a year, you would expect to receive one thousand dollars each year and then the original ten thousand at maturity. If you received one thousand per year for ten years, and nothing at maturity, you would hardly consider this a ten percent return, zero percent would be more like it.
Annuities do not mature like CDs. There is no magic time when you get your principal back. Instead, each check you receive blends your own money and a return from the insurance company. How much you get depends largely on how you choose to receive your money and how long you live.
The largest checks will go to buyers who chose an annuity that pays one person until the day he or she dies and nothing to an estate. If you choose an annuity that covers two people, say a husband and wife, the checks will be smaller. You may also be offered other options such as a guarantee that the annuity will pay for at least ten years, regardless of whether you live that long or an annuity with an inflation adjustment that initially underpays the recipient in return for an increased check as time goes by and prices increase. These are just some of the possibilities. Each of these options will affect the size of the checks received.
The most important factor determining what you will receive; however, is when the insurance company assumes that you will die. As with life insurance, mortality tables are very important here. Insurance companies study large populations to determine when people will die. The younger you are when you start receiving payments, the lower the monthly amount you will receive, all other things being equal.
People who buy annuities but die young will be cheated, while Methuselah makes out like a bandit. As mentioned previously, annuities are insurance against outliving your money. If you are looking to fund a monthly stream of payments, perhaps to offset an anemic pension or supplement social security, annuities are ideal.
But if you are looking for a savings account, never buy an annuity instead of a CD. The CD is guaranteed by the US government through FDIC or other bank or credit-union guarantee funds while the annuity is backed solely by the financial strength of the insurance company behind it.
This, in an of itself, does not make it dangerous. Some insurance companies have paid like clockwork for a century, but before buying an annuity, check Moody’s, Fitch, or Standard and Poor’s for an opinion on the creditworthiness of the company. Check Weiss Ratings also. Weiss Ratings are paid for by the buyer of the insurance, rather than the insurance company, and are less likely to sugar-coat problems in return for business from the insurance companies.
The bigger problem is confusing an investment meant for short-term savings with one meant to hold your money indefinitely. Once you annuitize, kiss your principal good-bye. Although a long-lived purchaser may be eminently pleased with an annuity from a rock-solid company, he can never expect to demand the return of his cash once the checks start. The best he can do is sell an annuity to a third party at a substantial loss.
A buyer who is hard-up for cash and attracted by the seemly-higher returns of an annuity will be stunned to discover that while his monthly income is higher, he no longer has a pot of money at maturity. If he needs savings, he will be worse off, even though his monthly income will increase.
To sum up, Certificates of Deposit are best used by conservative savers who want to be able to access their money whenever necessary, even if they have to pay a penalty to get their cash before maturity. These accounts are covered by insurance to the limit set the the US Government.
Annuities are best purchased by people who want to increase their monthly income at the expense of being able to access their cash. Annuities can be thought of as life insurance in reverse and are excellent protection for people worried about outliving their money. They rest on the credit-worthiness of the company issuing them and there are no government guarantees.
The rates of return quoted for annuities will always look larger than those quoted for CDs because annuities return part of the original investment with each payment, while CDs pay interest only and the entire amount of the original investment is available for withdrawal at maturity. Annuity returns are deceptive because their attractiveness rests largely on whether the person buying them lives longer or shorter than predicted. The longer you live, the better the deal.