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Fixed annuities vs. CDs: Which is better for your retirement savings?
When it comes to retirement savings, most people find their balances to be stress-inducing. A recent study from AARP found that more than half of adults 50 and older were worried they didn't have enough money to support themselves in retirement.
For those looking for relatively "safe" investments, annuities and certificates of deposit (CDs) are two common tools. However, these options aren't appropriate for everyone, and they may not be helpful for your retirement planning.
In this breakdown of annuities vs. CDs, learn about their rates, fees, and returns so you can decide if either choice is right for you.
What is a certificate of deposit (CD)?
A CD is a type of deposit account you can open through most banks and credit unions. You make a lump sum deposit and commit to leaving the money untouched for a certain period, such as six months or five years.
One of the major benefits of CDs is that they typically pay a higher annual percentage yield (APY) than traditional savings accounts. In fact, some of the best CDs today offer rates over 4.00% APY — nearly 10 times the national average APY for savings accounts.
Another benefit is that the rate is locked for the duration of the CD's term, so you can earn a steady and predictable rate of interest and grow your money over time.
However, there is a significant drawback: CDs aren't liquid. Your money is locked in for the duration of the CD's term. If you withdraw money before the maturity date, you'll have to pay substantial penalties.
Read more: Why a CD should be part of your retirement savings plan
What is a fixed annuity?
A fixed annuity is a contract between you and an insurance company. With a fixed annuity, the insurance company commits to paying you a minimum rate of interest and a fixed amount of periodic payments.
Annuities can be immediate or deferred. With an immediate annuity, you start receiving payments right away. In a deferred annuity — a popular option for those planning for retirement — you start receiving payments years later.
A fixed deferred annuity has an accumulation period, where your payments earn interest at a rate set by your insurance company. There is usually a minimum guaranteed rate of interest, plus a current rate; as the market changes, your current rate may change along with economic conditions.
The money in an annuity is tax-deferred, meaning it can grow without affecting your tax bill until you start receiving payments. And annuities are customizable; when you purchase an annuity, you can decide how long you want to receive payments. You can also indicate how the account should be handled after your death. For example, you can sign up for a joint annuity so your partner continues to receive payments, or you can choose a single annuity.
Annuities vs. CDs: Key differences
For those approaching retirement, investing can be scary. The market can fluctuate a great deal, so there's always the risk of losing large portions of your retirement fund. That’s why "safe" options like CDs and annuities are so appealing — you can grow your money at a steady rate without worrying about market risk.
Before putting your money into an annuity or CD, there are some key differences between these options to keep in mind.
Issuer
CDs are opened through banks and credit unions. As long as the financial institution you choose is federally insured, your CD deposits are protected by the FDIC (or the NCUA if it’s a credit union) up to a maximum of $250,000 per depositor, per institution, per ownership category. So there's no risk of losing money if the bank fails.
Annuities are issued by insurance companies and regulated by your state's insurance commissioner. Annuities aren't secured by federal insurance. However, state guaranty associations do offer protection; state guaranty associations provide at least $250,000 of coverage per customer, per company, in all 50 states.
Fees
In general, CDs tend to be lower cost than annuities. They rarely have monthly or annual fees, and they aren't subject to commissions or administrative costs.
The only time you have to worry about fees with CDs is if you withdraw money before the maturity date. If that happens, the CD penalty can mean forfeiting anywhere from three to 24 months’ worth of interest.
Annuities work quite differently. Since they're sold by agents, they involve commissions. The commission amount is usually included within the terms of your contract, but it can range from 2% to 8% of the annuity's total premium.
Annuities can also have administrative fees and surrender fees. Surrender fees apply if you take out money before the contract allows it, and can be about 10% of the contract's value.
Minimum deposit
CDs are usually easier to open than annuities for those with limited cash flow. Banks can set their own account minimums, but you can usually open a CD with less than $1,000.
Annuities require a larger upfront investment. Depending on the insurance company behind the annuity, the minimum can be anywhere from $5,000 to $100,000.
Rates
With a CD, your rate is locked for the entire term. Depending on what rates are at the time you open the CD, that means you could lock in a relatively high rate for several years.
Fixed annuities usually have two components: A guaranteed base rate and a current rate. The guaranteed rate is fixed for a specific period, such as three to five years. After that, the rate may change along with market conditions.
Taxes
Annuities are tax-deferred, so the money you put into an annuity can grow tax-free. The money isn't taxable until your earnings are withdrawn.
With CDs, your earnings are taxable during the tax year they're earned.
Read more: How to avoid taxes on CD interest
Annuity vs. CD: Which is best for you?
If you're several years away from retirement, an annuity could be a better choice than a CD since you have more time for your premiums to accumulate interest.
But, if you're nearing retirement or are already retired, an annuity is unlikely to make sense, as the fees negate some of the value in retirement. Instead, tucking money into a CD with a term of five years or less can help you save for shorter-term goals or provide modest growth for your savings.
However, if you have 10 years or more until you retire, neither option will be a great place to put the bulk of your retirement savings compared to investing in the stock market. That’s because the interest rates on annuities and CDs are usually under 5%, while historically, the stock market has provided average annual returns of about 10%. So you'd miss out on significant growth by only keeping your money in CDs or annuities.
Not sure what's best for you? Set up a meeting with a certified financial planner (CFP) or financial advisor to review your finances and develop a retirement plan.
Read more: 5 questions to ask your financial advisor before year-end
