Some investment options are straightforward, but others are more complex. A certificate of deposit is a common type of investment that's relatively straightforward. In contrast, an indexed annuity is considered a sophisticated investment with complex rules. Investors can profit from both types of investments, but it is vital to understand the rules of both before choosing.
A certificate of deposit is a fixed sum deposited with a financial institution for a specified period of time. When the CD matures, you receive the principal amount and the agreed-upon interest.
An annuity is a contract that you enter into with an insurance company. You pay a specific amount to the company, and It agrees to make periodic payments for life starting at a predetermined date in the future.
Two basic types of annuities exist: fixed and variable. For a fixed annuity, the insurance company agrees to a fixed payout based on a fixed interest rate. The rate of return on a variable annuity fluctuates based on the performance of its underlying assets.
An indexed annuity is often referred to as an equity-indexed annuity or fixed-indexed annuity. It is a hybrid of fixed and variable annuities. Indexed annuities' interest rates vary more than the rates on fixed annuities, but less than the rates on variable annuities.
How the Investment Works
The easiest way to invest in a CD is by acquiring one at a bank. Most banks sell CDs with varying interest rates and maturity dates. Some CDs mature in a few months, others in five years of more. You can purchase a CD that has a fixed interest rate, or one with interest dependent upon the performance of the stock market.
An indexed annuity has a minimum guaranteed interest rate that's usually tied to the performance of the S&P 500. According to the Financial Industry Regulatory Authority, indexed annuities typically pay at least 87.5 percent of the premium paid, and an interest rate of 1 to 3 percent.
It is possible for an insurance company to default on its minimum guarantee. An indexed annuity can exceed the minimum guaranteed interest rate, but many insurance companies cap the amount of interest their annuities can earn.
Investing with low risks is the primary advantage of buying a CD. Unlike an indexed annuity, many CDs are issued by financial institutions backed by the Federal Deposit Insurance Corp. If the bank goes under, you will not lose your CD investment.
A major advantage of investing in an indexed annuity is the ability to capitalize on a rising stock market, while limiting your risk in a downward market because of the minimum return feature of an indexed annuity. You can earn more interest than investing in fixed annuities, without the risks associated with variable annuities.
Investors can shop around for CDs with the highest interest rates, but CDs typically offer lower yields than other investments, such as bonds and mutual funds. Another disadvantage of investing in a CD is that you are penalized for withdrawing your money before the maturity date.
A disadvantage of indexed annuities is that they typically come with a steep surrender charge. The fee varies per insurance company, but some surrender charges can reach as high as 20 percent and last for up to 15 years. You also must pay a 10 percent tax penalty for withdrawing your money early from an indexed annuity.
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