By Carlos Dias Jr.
Published: July 7, 2016 on www.marketwatch.com
Many people are familiar with the "4% Rule" — the age-old advice for retirees who were told to withdraw 4% of their retirement accounts since the market averages a 7% return every year on investment accounts. But with historically lower interest averages and lower averages of returns from stocks and bonds, the market has had too many fluctuations for the rule to work. For the average retiree (who is now also living longer historically than previous retirees), the 4% rule can lead to a decimated nest egg.
Retirees need to choose wisely when it comes to their investments. There are many differences among two of the most popular investment tools — Certificates of Deposit (CDs) and annuities.
Historically, bank CDs have been more favored as they are considered one of the safest investments available. This is because Federal Deposit Insurance Corporation (FDIC) insures them up to $250,000 if the bank fails, unlike fixed annuities which aren't insured by FDIC even if they are purchased through a bank. In contrast, fixed annuities are guaranteed by the insurance company issuing them, so their level of safety is based on the financial security of the company that issues them.
What are some other key differences between CDs and annuities?
While CDs might be "safer," their interest rates are generally lower and returns are not insulated against inflation, with rates dropping more and more given the state of the economy. Interest earned from a CD is taxable income (1099) which can lead to taxes on benefits from Social Security. Annuities offer tax-deferred growth and earnings that are triple compounded — you earn interest, interest on the principal, and interest on the money that you would have paid in taxes.
Most banks will charge a penalty for withdrawing from a CD before maturity, and the penalty usually increases every time the CD is renewed at maturity. This includes spouses if they withdraw from the CD in many cases, even if one of the spouses has passed away. Annuities have fixed penalty charges whose conditions don't change, and you can withdraw up to about 10% of your principal (or at least the interest) annually without a penalty. And if one spouse were to die, the remaining spouse has access to the funds completely penalty free (if not a joint annuity).
For long-term care, if you are confined to a nursing home, need home health care, or have to move in assisted living, most banks will also charge you the penalty for withdrawing from a CD before maturity. The majority of annuities either have a nursing home "confinement waiver" (usually 90 days or less), and some provide a "double" home health care benefit for at least five years that won't leave you in financial ruin if you've depleted all of your funds.
With regard to lawsuits, CDs are categorized as "non-exempt" — therefore they are free game for creditor confiscation. Annuities in some states are exempt, and therefore, safe from lawsuit claims. Make sure you understand your state's laws before you make a decision and buy an annuity.
In terms of reaching your heirs if something were to happen to you, CDs must go through a probate process unless if they are placed in a living or irrevocable trust. And if the CD is co-owned by parents and children to avoid the probate process, then children potentially let the CD be "non-exempt" if they were to face a lawsuit. Annuities can go through a process to designate a beneficiary and bypass the probate process.
CDs have limits for deposits, therefore owners must own various bank accounts to deposit larger sums. They are insured up to $250,000 by FDIC. Annuities, while "completely guaranteed and insured" by the issuing company, may not be entirely safe, again, depending on the financial security of the issuing entity. However, they do not have deposit limits.
Annuities guarantee income for life. During your lifetime, fixed annuities provide a guaranteed minimum interest rate for earnings. It's the only investment that can be outlived or planned for multiple family generations. CDs offer no lifetime income. They offer a guarantee if the bank fails but no minimum interest earnings. If funds that exceed interest earnings are withdrawn, the entire benefit will end. And when the CD owner passes on, the accounts are distributed all at once in a lump sum—versus the four options annuities provide (lump sum, non-qualfied "stretch," five-year rule, or annuitization).
In conclusion, while CDs may have once been a guaranteed, safe, tried and true investment for retirees to obtain retirement earnings, fixed annuities may be the better alternative with better rates, guaranteed minimum earnings, and the option to extend those earnings and benefits of tax-deferred compounded growth to your loved ones.