Fixed Rate Annuities vs. CDs: What Are the Differences?

When considering safe investment options, both fixed rate annuities (a.k.a. fixed annuities or MYGAs) and Certificates of Deposit (CDs) are popular choices. These financial products offer a guaranteed return on your investment, making them attractive to conservative investors. However, understanding the nuances between a fixed annuity and a CD is crucial in making an informed decision that aligns with your financial goals.

What is a Fixed Rate Annuity?

A fixed rate annuity or fixed annuity is an insurance product that guarantees a specific interest rate for a certain period, typically 2-10 years. Investors pay a lump sum to an insurance company, which then provides regular interest payments over time. The interest rate, which is usually an annually compounded rate, is locked in, protecting against market fluctuations (Bankrate). Fixed annuities are also known as Multi-Year Guaranteed Annuities (MYGAs) (PlanEasy).

How is the Annuity Interest Rate Determined?

The interest rate for a fixed annuity is determined by the insurance company and is influenced by several factors, including:

• Market Conditions & the Fed: Insurers consider current economic conditions and interest rates when setting rates. Fixed annuity rates tend to follow the rise and fall of Treasury yields and the Fed Funds Rate. 
• Insurer's Rating: The insurance company’s AM Best rating can impact the rates offered. Typically, having a stronger rating, which indicates stronger credit and financial strength, results in an insurer offering a lower guaranteed interest rate and vice versa. Hence, B-rated carriers often offer higher rates than A-rated carriers, but there can be anomalies.
• Term Length: Longer terms generally have higher rates but not always. 
• Liquidity: If a fixed annuity offers no liquidity or free withdrawals, that product will have higher rates than the version with penalty-free withdrawals. Often for the same product, the no-liquidity version will charge a reduction in rate to offer free withdrawals.  

What is a Certificate of Deposit (CD)?

A Certificate of Deposit (CD) is a time deposit offered by banks and credit unions. In exchange for locking up your money for a set term, typically ranging from a few months to several years, you receive a fixed interest rate. CDs are insured by the FDIC or NCUA up to certain limits, providing a layer of security (Guardian Life).

Types of CDs

• Traditional CDs: Offer a fixed interest rate for a specified term, usually ranging from 6 months to 5 years.
• Jumbo CDs: Require a larger minimum deposit, often $100,000 or more, and usually offer higher interest rates.
• No-Penalty CDs: Allow you to withdraw funds before maturity without incurring a penalty, though they may offer slightly lower interest rates.

How CD Rates Are Determined

CD rates are influenced by:

• Federal Reserve Policies: Changes in the Federal Reserve’s benchmark interest rate can impact CD rates.
• Bank Competition: Banks may offer higher rates to attract more customers, especially in a competitive market.
• Term Length: Longer-term CDs generally offer higher rates to compensate for the lack of liquidity.

Fixed Rate Annuity vs. CD: A Comparison Table

Fixed Annuity vs CD - Key Differences in Further Detail 

1. Issuer and Regulation

• Fixed Annuities: Issued by insurance companies and regulated by state insurance departments. They are not backed by FDIC insurance but by the claims-paying ability of the insurer (New York Life). Additionally, state guaranty associations provide a level of protection, but coverage limits vary by state.
• CDs: Offered by banks or credit unions and insured by the FDIC (for banks) or NCUA (for credit unions) up to $250,000, providing a government-backed guarantee (Investopedia).

2. Interest Rates

• Fixed Annuities: Typically offer higher interest rates compared to CDs. This higher rate is due to the longer commitment period and the insurer's ability to invest in a broader range of assets (Kiplinger). Also, insurance companies can often invest in longer-term, higher-yielding investments as their capital is stickier than bank capital.
• CDs: The interest rate is fixed and varies depending on the term length and current market conditions. Shorter terms usually offer lower rates, while longer terms offer higher rates (Forbes). CD rates are generally lower than fixed annuity rates as banks are significantly influenced by short-term interest rates and their need for liquidity.

3. Tax Treatment

• Fixed Annuities: Grow on a tax-deferred basis, meaning you don't pay taxes on the interest until you withdraw the money. This feature can be advantageous for long-term growth, allowing your investment to compound without the drag of annual taxes (SmartAsset). Withdrawals from annuities are taxed as ordinary income, and early withdrawals (before age 59½) may be subject to a 10% IRS penalty.
• CDs: Interest earned is typically taxed annually as ordinary income, even if you choose to roll over the interest into another CD (USAA). This means you could lose a portion of your earnings to taxes each year.

4. Liquidity and Early Withdrawal

• Fixed Annuities: Often come with surrender charges if you withdraw funds before a specified period, usually 2-10 years, where the surrender charge schedule usually aligns with the interest guarantee term period. For instance, a 5-year fixed annuity can offer a 5.00% rate guaranteed for five years with a surrender charge schedule of similar length of five years. The surrender charge usually starts at some percentage and declines each year until reaching zero at the end of the term. Some annuities offer a free withdrawal feature, allowing you to withdraw a portion of the account value each year without penalty (Blueprint Income). It's important to understand the surrender schedule before investing.
• CDs: Early withdrawals are subject to penalties, which vary depending on the bank and the term of the CD. The penalty is typically a few months' worth of interest (Forbes). Some CDs, like no-penalty CDs, may allow for early withdrawals without a penalty but may offer lower interest rates.

5. Insurance and Security - Are Fixed Annuities Safe?

• Fixed Annuities: Not insured by the FDIC. The safety of an annuity depends on the financial strength of the issuing insurance company. State guaranty associations provide a safety net up to certain limits (often ~$250,000) if an insurer fails, but these limits vary by state (Investopedia).
• CDs: Backed by the FDIC or NCUA up to $250,000 per depositor, per institution. 

6. Fees and Charges

• Fixed Annuities: Typically come with no fees, aside from any early surrender charges on amounts above the free withdrawal amount or any rider fees you pay for via a reduction in rate (Kiplinger). One example of a potential rider may be a free withdrawal rider that allows you to withdraw a certain amount each year; having this rider would be paid for via a lower rate relative to the no-liquidity version of the product. Another rider is a death benefit rider, but most fixed annuities already come with a death benefit without having to pay for it.  
• CDs: Typically come with no fees, except for penalties on any early withdrawals. The main cost associated with CDs is the early withdrawal penalty, which can reduce the effective yield if you need to access your funds before maturity (Guardian Life).

Fixed Annuity vs. CD - Pros and Cons

Fixed Rate Annuity Pros & Cons

• Pros:
  • Higher interest rates compared to CDs
  • Tax-deferred growth, allowing for compounding
  • Can grow funds for longer terms
  • Flexibility in payout options, including lifetime income
  • No fees, except surrender charges on early withdrawals above the free withdrawal amount
• Cons:
  • Limited liquidity, especially if the free withdrawals feature isn't chosen
  • Surrender charges on any amounts withdrawn above the free withdrawal amount
  • Not FDIC insured, relies on insurer's financial strength

CDs Pros & Cons

• Pros:
  • FDIC or NCUA insured up to $250,000
  • No fees, aside from early withdrawal penalties
  • Shorter terms available, making it more liquid
• Cons:
  • Lower interest rates compared to annuities
  • Interest taxed annually, reducing compounding benefits
  • Penalties on any early withdrawals, as no free withdrawal provisions are available
  • Limited growth potential as terms are shorter and interest is taxed yearly

When to Choose a Fixed Annuity

A fixed annuity might be suitable if you are looking for:

• Long-Term Growth: If you have a longer investment horizon and want your money to grow on a tax-deferred basis.
• Guaranteed Income: You desire a guaranteed income stream in retirement, with options for lifetime payouts.
• Higher Fixed Returns: You seek higher fixed returns compared to what CDs currently offer.
• Estate Planning: You want to provide a death benefit to beneficiaries.

When to Choose a CD

A CD might be more appropriate if you prefer:

• Short- to Medium-Term Investment: If you need access to your money in the short to medium term.
• Security: You want the security of FDIC or NCUA insurance.
• Liquidity Needs: You need the option to choose shorter terms or no-penalty CDs for easier access to your funds.

Tax Considerations

When evaluating fixed annuities and CDs, it's important to understand the tax implications:

• Fixed Annuities: Taxes are deferred until withdrawal, allowing the investment to grow without annual tax deductions. However, withdrawals are taxed as ordinary income. If withdrawn before age 59½, a 10% early withdrawal penalty may apply.
• CDs: Interest is taxed annually as ordinary income. This could impact your overall return, as you'll pay taxes each year, potentially reducing the compounding effect.

Market Context and Historical Performance

The attractiveness of fixed annuities and CDs can vary based on market conditions:

• Current Market Conditions: In a low-interest-rate environment, fixed annuities often provide more competitive rates than CDs. Insurance companies can invest in a broader range of assets, potentially offering higher returns.
• Historical Performance: Historically, fixed annuities have offered higher returns than CDs during periods of low interest rates due to their ability to invest in long-term, higher-yielding investments.

Additional Use Cases

Case Study: Retiree Seeking Guaranteed Tax-Deferred Growth

A 65-year-old retiree looking to grow his funds for five years in a tax-deferred manner with the intention of not needing any of the funds during that time may find a fixed annuity appealing, as CDs of similar term were not offering as high of a rate. By investing a portion of retirement savings in a fixed annuity, he can receive guaranteed interest without having to worry about market volatility and earn more than a CD.

Case Study: Young Investor with Short-Term Goals

A 30-year-old investor saving for a down payment on a house in a year might prefer a 1-year CD. A short-term CD offers a guaranteed return with the safety of FDIC insurance, making it a suitable choice for short-term savings goals. There are 1-year fixed annuities available but not many. Most fixed annuities start at 2 years and go to 10 years. 

Diversification and Portfolio Considerations

Both fixed annuities and CDs can play a role in a diversified portfolio:

• Fixed Annuities: Suitable for the portion of a portfolio allocated to long-term growth. They can provide stable guaranteed, tax-deferred growth and reduce overall portfolio risk.
• CDs: Ideal for the cash or shorter-term fixed-income portion of a portfolio. They offer safety and liquidity, making them a good option for emergency funds or short-term goals.

Regulatory and Safety Considerations

Understanding the regulatory environment and safety nets for these products is crucial:

• Fixed Annuities: Regulated by state insurance departments, offering protections through state guaranty associations. These associations provide a safety net if an insurance company fails, but coverage limits vary by state.
• CDs: Regulated by federal and state banking authorities. The FDIC or NCUA insures deposits up to $250,000 per depositor, per institution, providing a high level of security.

Step-by-Step Guide to Purchasing

Purchasing a Fixed Annuity

1. Assess Your Needs: Determine your financial goals, risk tolerance, and desired income.
2. Compare Annuities: Shop around PlanEasy's Fixed Annuity Marketplace for fixed annuities from reputable insurance companies.
3. Review Terms: Carefully review the terms, including interest rate, surrender charge period, and fees, if any.
4. Consult a Financial Professional: Seek professional guidance from a PlanEasy agent to ensure the annuity aligns with your overall financial plan.
5. Complete the Purchase: Work with a PlanEasy agent to submit an application to the insurance company and subsequently fund your account.

Choosing a CD

1. Determine the Term: Decide how long you can lock in your funds.
2. Compare Rates: Compare rates from different banks and credit unions.
3. Check the Institution’s Ratings: Verify the bank or credit union's financial health and FDIC or NCUA insurance status.
4. Understand Early Withdrawal Penalties: Be aware of penalties for early withdrawal.
5. Open the CD: Open the CD with the chosen institution, either online or in person.

Frequently Asked Questions (FAQs)

What Happens If a Bank Fails With My CD?

If a bank fails, the FDIC or NCUA will cover the principal and accrued interest on your CD up to $250,000 per depositor, per institution.

Can I Lose Money in a Fixed Annuity?

The principal is protected in a fixed annuity, backed by the credit of the issuing insurer. If you withdraw funds above the penalty-free, free withdrawal amount, if any, you could face surrender charges. The guarantees are backed by the insurance company's financial strength, not by a government agency.

Conclusion

Both fixed rate annuities (a.k.a fixed annuities) and CDs have their unique advantages and disadvantages. Your choice between a fixed annuity and a CD will largely depend on your financial goals, risk tolerance, and investment horizon. Fixed annuities typically offer higher returns and tax-deferred growth, making them a compelling option for long-term investors. CDs, on the other hand, provide safety and simplicity with FDIC insurance, making them ideal for conservative investors seeking short to medium-term growth.

For those interested in exploring fixed annuities further, you can learn more about MYGAs and how they work in our detailed article (PlanEasy). Additionally, if you're ready to shop for market-leading fixed annuities, you can visit our Fixed Annuity Marketplace to compare options and find the best rates.

Carefully consider your individual financial situation and consult with a financial professional to determine which option aligns best with your goals.

Sources:

1. Bankrate: Fixed Annuities vs. CDs
2. Guardian Life: CDs vs. Annuities
3. New York Life: CD vs Fixed Deferred Annuity
4. Investopedia: CDs vs. Annuities
5. Forbes: Annuity vs. CD
6. Blueprint Income: 9 Key Differences Between Fixed Annuities and CDs
7. Kiplinger: Why Fixed Rate Annuities Pay More Than Bank CDs
8. USAA: Retirement Annuities Higher Rates
9. SmartAsset: Annuity vs. CD
10. PlanEasy: What Are MYGA Annuities and How Do They Work?
11. PlanEasy: Fixed Annuity Marketplace

Disclosure: This article is for informational purposes and does not constitute financial or investment advice.