Fixed Annuities versus CDs versus Treasuries

Rising interest rates have certainly gotten a bad rap in 2022, commonly blamed for the worst losses in the stock market since the Great Recession (not counting the very temporary Covid dip of 2020) to an almost as painful beating in the bond market. Aggressive rate hikes have squeezed excess liquidity out of the markets, increased the costs of borrowing for consumers and companies alike, and hurt the value of supposedly safe fixed-income instruments previously locked in at lower interest rates. Who wouldn’t be upset after having enjoyed the longest bull market ever, thirty-year fixed rate mortgages at three percent, and other benefits of an easy money supply over the past several years? 

I will tell you who. Despite all the financial gains from 2009-2021, there was a segment of cash-hoarding savers stuck with accounts earning near zero percent for over a decade. It was a time when certificates of deposit (CDs) earned the nickname, “certificates of disappointment”. These are the people who finally have something to write home about. While the path of rising interest rates does devalue existing bonds and fixed-income funds per the old seesaw analogy, it can provide ripe opportunities going forward.

Ultra-conservative savers are likely to consider CDs, fixed annuities, or treasuries.  As of November 2022, some of the best five-year CDs are offering a 4.25% APY (annual percentage yield).  Sticking with the same duration, the top five-year fixed annuity rates are between 5.00-5.25%.  Lastly, a five-year treasury note offered a yield of 4.27% as of November 1, 2022.

Despite having the same duration and ability to “guarantee” interest rates, there are some key differences between these three options.  The lenses through which to analyze each product are safety, liquidity, and taxability.

Safety

A treasury can be considered the ultimate safe haven. It is considered a risk-free asset as both its principal and interest are backed by the “full faith and credit of the US government”. 

A certificate of deposit can be considered very safe as the depositor’s account can be backed by the FDIC (Federal Deposit Insurance Corporation) which is backed by the federal government, should the bank run into financial trouble.  However, the FDIC will only insure up to $250,000 of accounts for the same owner at the same bank, this includes savings, checking, and money market accounts. 

A fixed annuity is an insurance contract issued by an insurance company that can also guarantee its customer’s principal and interest rate, however, it is backed by the strength of the issuing carrier.  Therefore, more due diligence may be necessary to fully understand the financial strength of the insurance company.  Perhaps the most trusted rating source for insurance/annuity companies is AM Best, which grades companies on a scale ranging from “D” for Poor up to “A++” for Superior.  In the event an annuity carrier could not meet its obligations, the National Organization of Life and Health Guaranty Associations, which is managed on a state-by-state basis, would step in to fulfill outstanding obligations.  While states vary, most are consistent with the NAIC (National Association of Insurance Commissioners) Model Act and cover at least $250,000 of present-value annuity benefits.

Liquidity

A treasury note cannot be redeemed prior to its maturity, it must be sold.  Selling a treasury can be done through a bank, broker, or dealer.  It’s important to note that this is where interest rate risk can be a factor as if prevailing rates are higher at the time of sale than when the note was originally obtained, it may sell for a discount.

Regarding CD’s, federal law sets a minimum penalty on early withdrawals, but no maximum. For a five-year CD, it is common to see a penalty ranging from 12 months interest up to 24 months interest.  Some CDs may allow a partial, penalty-free withdrawal, but these differ from bank to bank.

Fixed annuities are similar in that they typically have a surrender period that matches their maturity.  It is common for this to be a decreasing surrender schedule in which the penalty lessens each year as it nears maturity.  However, many annuities offer penalty-free withdrawals of up to 10% of the annuity value, interest only, when used for IRA Required Minimum Distributions, or may waive the surrender penalty entirely if the annuity holder becomes chronically or terminally ill.  Perhaps the most notable difference is that even when held outside of qualified retirement accounts, any withdraws before Age 59.5 may be subject to the 10% IRS premature distribution penalty.  This is why fixed annuities are more suitable for investors in or near retirement.

Taxability

The interest on treasury notes is fully taxable at the federal level but is tax-free at the state and local levels. Each year, the Treasury Department will send the investor a Form 1099-INT to report such taxable interest. Investors who sell a treasury on the secondary market for a gain will be subject to the same short-term or capital gains taxes as they would any other security.

A CD is similar in that the bank will issue a Form 1099-INT each year in which the CD holder must report the interest (this assumes the CD is not held in an IRA).  This interest is taxed as income at both the federal level and state levels.

A fixed annuity differs from the prior two vehicles in that interest grows tax-deferred, avoiding the reporting of 1099-INT every year.  Interest will only be reported when the annuity holder begins withdrawing their funds.

This information is for educational purposes only and should not be considered individual advice.  Please consider your own financial situation, goals, objectives, and professional guidance before making any investments. Readers should contact their tax or legal professionals for any specific tax or legal advice.

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(Featured image by 8385 via Pixabay)

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