Annuities vs. Certificates of Deposit (CDs)
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Diversification is the key to a healthy financial portfolio, especially when it comes to retirement planning. An essential part of diversifying means having funds in guaranteed, interest-bearing vehicles to offset the risk inherent to financial markets.
Two such vehicles are annuities and Certificates of Deposit (CDs). While both are typically considered stable, secure retirement investments, there are significant differences to be aware of. Here, we’ll answer key questions about annuities and CDs, including:
What are CDs, and how do they work?
How do CDs and annuities differ?
What are the financial benefits and drawbacks of each?
Understanding CDs
A Certificate of Deposit (CD) is a savings account with a fixed interest rate and fixed date of maturity. Unlike regular savings accounts, CDs typically offer a higher interest rate when you agree to leave your deposit untouched for a set period of time, from a few months to several years. CDs are considered a safe investment option as they are protected by Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) insurance up to $250,000 per account. CDs are a popular choice for those seeking to grow their money with minimal risk.
Understanding annuities
An annuity is a contract with an insurance company in which you pay a lump sum or series of premium payments and, in return, receive a regular stream of income. These payments can start right away or within one year (with an immediate income annuity), or at some point in the future (with a deferred income annuity). Think of an annuity as a simple, guaranteed way to get the regular income you need to live in retirement and mitigate the risk of outliving your savings.
Annuities that earn interest over time before payouts begin are considered deferred. These come in various forms, including fixed, variable, and fixed-indexed, each offering different terms, benefits, and risks. Fixed annuities are comparable to CDs because they both guarantee a set interest rate on your principal. Additionally, both accrue interest over time and incur penalties if funds are withdrawn before a pre-determined time period.
Certificates of deposit vs. annuities
Understanding the differences between CDs and fixed annuities can help you choose the option that best suits your goals and retirement planning strategy. Considerations include:
Risk level/safety: Both fixed annuities and CDs are considered conservative investment options. However, while CDs are insured up to $250,000 per account by the FDIC or NCUA, annuities are backed solely by the issuing insurance company.
Issuing company : If offered by a bank or credit union — or any other financial institution covered by FDIC or NCUA insurance — CDs are insured up to $250,000 per account. However, the security of an annuity depends solely on the insurer’s financial stability and claims paying ability. When looking into annuity providers, the first step is to find out how they are rated by the top independent rating agencies — including A.M. Best, Moody’s, Standard & Poor’s, Moody’s, and Fitch Ratings.
Flexibility: Annuities offer more flexibility in terms of payment options and can be tailored to provide regular income payments for life or a specified period. CDs, on the other hand, have a fixed term and interest rate with customization options that are limited at best.
Interest rates: CDs typically have fixed interest rates for the term of the certificate. Annuities offer fixed, variable, or indexed rates, potentially providing higher returns than CDs — especially with variable and indexed annuities, where the returns are linked to variable investments and market indices, respectively. If you are considering CDs because of their guaranteed interest, you might also consider fixed annuities, which also provide a fixed interest rate. Interest rates for fixed annuities are generally higher than CD rates because you typically must hold the investment for a longer period.
Length of holding: CDs have terms ranging from a few months to several years. Annuities are longer-term investment vehicles designed to provide income during retirement. For example, the Guardian Fixed Target AnnuitySM offers a guaranteed rate of return for three-to-six-year periods. You can select the time period that best fits your retirement plan.
Liquidity: Liquidity refers to how quickly and easily an investment can be converted into cash without significant loss of value. CDs may offer greater liquidity than fixed annuities because the holding period is generally shorter. However, both CDs and annuities impose penalties for early withdrawal. Early withdrawal from an annuity may incur a surrender charge, which can significantly reduce the earnings and, potentially, the principal.
Early withdrawal penalties: When you withdraw money before a CD’s maturity date, you'll have to pay an early withdrawal penalty, which can deplete the interest earned and, potentially, the principal. Annuities may also have surrender charges for early withdrawals, but these typically decrease over time. Early withdrawal from a fixed annuity will typically trigger tax consequences and additional IRS penalties if taken before the age of 59½, as annuities are usually treated as qualified retirement money (unless purchased with after-tax dollars).
Tax treatment: The interest earned on CDs is typically taxable in the year it is earned. However, if the CD is purchased with qualified retirement funds in an individual retirement account (IRA), taxes are deferred until you make withdrawals in retirement. (But note that CD principal and interest in an IRA are also subject to early withdrawal penalties if it is taken before age 59½.) Annuities offer tax-deferred growth, meaning taxes on earnings are not paid until the funds are withdrawn, potentially providing a tax advantage over CDs; however, early withdrawal penalties still apply to annuities purchased with qualified retirement funds.
Annuities vs. CDs: Which is right for you?
Before determining which vehicle is right for you, it’s a good idea to use a retirement calculator to determine where you stand in relation to your personal finance and retirement goals. If you have maxed out your 401(k) and IRA contributions, you might want to consider a CD, an annuity, or both. If you prioritize safety and stability over a potentially higher return, both CDs and fixed annuities are smart choices for securing a guaranteed interest rate.
CDs are particularly well-suited for conservative investors or those nearing retirement who cannot afford the risk of losing their capital. Additionally, if you have a specific, short-term financial goal in mind, such as saving for a down payment on a house over the next five years, you may prefer the predictable, fixed interest rate that CDs offer.
Alternatives to annuities and CDs
Of course, CDs and annuities are just two of your retirement savings options. Others include:
Traditional savings accounts: The simplest alternative to CDs and annuities is to leave your money in a traditional savings account. CDs and annuities generally yield higher returns than traditional savings accounts, but you must agree to lock in these funds for a set period of time.
Mutual funds: Another alternative for your savings is a mutual fund, which offers the opportunity to invest in a diversified portfolio of stocks, bonds, or other securities, managed by professional investors. Mutual funds can provide higher potential returns than CDs and annuities, with the flexibility to choose funds that match your level of risk tolerance. Mutual funds are sold by prospectus and may lose value.
Stocks: Individual stocks have the potential for high returns but also come with a higher risk of loss. The value of stocks can fluctuate significantly based on market conditions, company performance, and broader economic factors.
Bonds: Bonds are another alternative, offering a middle ground between the safety of CDs and fixed annuities and riskier stock investments. When you purchase bonds, you’ll receive regular interest payments and a return of the bond's face value at maturity. Bonds range in safety from ultra-secure Treasury bonds to higher-yielding but riskier corporate bonds.
Guardian can help
Before purchasing an annuity or CD, consult a Financial Professional about the potential benefits and risks of each. If you don’t have someone to speak to, a Guardian Financial Professional can explain your options and help you decide what makes sense for your retirement plan.