Q: We have attended many free dinner seminars, andequity-indexed annuities seem to be the flavor of the month. We like some of the features, but we don't like the hidden costs of the annuities and the steep surrender charges and fees.
Someone told my husband that we should look into something called equity index linked CDs. Could you tell us how these CDs work and whether you think they are a good product where we'd find them? I think they are a great alternative to the equity-indexed annuities. They are also a good choice for some of the fixed assets allocated to your portfolio. For tax purposes, they are considered contingent payment debt instruments, so they work best in an IRA or other type of tax-deferred account. They make no cash payments until maturity, but if these CDs are held in a taxable account, the owner must report original issue discount interest each year, which is taxed at ordinary income rates.
These CDs are issued by banks, and your principal is guaranteed through the Federal Deposit Insurance Corp. The principal is protected, and rates of return are linked to one of the many stock, bond or commodity indexes. The most common indexes used are the Dow Jones industrial average and the S&P 500.
Some CDs will offer a minimum return, but others will only return your principal if the market index return iszero or below. A recent offering had a minimum rate of return of 12 percent and a cap or maximum 33 percent rate of return. The CD had a five-year maturity date, so the minimum 12 percent is equal to a 2.4 percent simple interest rate of return. The 33 percent maximum is equivalent to an annual 6.6 percent simple interest rate of return.
The average rate of return for a five-year nonequity linked CD is 2.97 percent, but the interest is compounded, providing a higher overall rate of return than simple interest. Equity CDs that don't offer a minimum rate of return usually have higher maximum rates or caps than those that do. In addition to the cap, you do not participate in any rate of return derived from dividends.
Your guaranteed rate of return may be higher with a traditional CD, and your rate of return may be higher by investing directly in the underlying index. The advantage of an equity index CD over a traditional CD is the potential for a higher rate of return. The advantage of an equity index CD over investing in an index is the lower risk and guarantee of not losing your principal.
Do not buy one of these if you think you will need the money before the maturity date. Some of the CDs offer the ability to redeem the CD quarterly or on some other periodic basis, but you may not get the full return of principal, and you will not receive any interest. There may be a secondary market for the CD, but it's doubtful you would get back the money you invested. Most CDs will have a clause that allows your heirs to get the principal if you should die before the maturity date.
These CDs are issued by banks but are a structured investment and trade like a security. If you are with a discount brokerage such as TD Ameritrade, Charles Schwab, Vanguard or Scottrade, ask their fixed income desk what is available.
Read the prospectus and make sure you understand what you are buying. If you don't understand the prospectus, you can hire someone to review it on your behalf. If nothing available is of interest to you, just wait for new issues. If you are working with a broker, ask that person to find an equity indexed CD for your situation.
