A CD annuity is an insurance product available to consumers in the United States that incorporates the long-term interest rate guarantee of a certificate of deposit (CD) into an annuity, which is a long-term, tax-deferred savings vehicle, often used to fund retirement programs. Annuities also enjoy attractive tax deferments on any interest earned, permitting the value to grow more quickly than a CD offering the same interest rate. CD annuities are generally regarded as niche annuities that were created to address the concern of some potential annuity purchasers that fluctuating interest rates created too much uncertainty.
Annuities are insurance products and can be sold only by insurance companies. Traditionally, they've been classified in one of three ways, depending on how their value grows. A variable annuity grows in value according to the actual investment of the principal in securities, which can result in gain or loss of value. An equity index annuity, also known as a fixed index annuity, grows by the periodic crediting of interest that is calculated based on the performance of an investment index like the Standard & Poor's 500 (S&P 500). When the index increases, interest is paid according to a formula based on the index's gain. When the index decreases, no interest is credited, but the account doesn't lose value, either. A fixed annuity grows by crediting an interest amount annually at a rate declared by the insurance company. Thus, while annuities are long term in nature, their interest rates fluctuate, resulting in some level of uncertainty for the investor. The CD annuity represents a fourth classification of annuities, one without any fluctuation in interest rates prior to maturity.
A CD is sold by a bank and guarantees to pay interest at a set rate upon maturity. Long-term CDs that mature in more than a year from the date of purchase pay interest annually at the rate declared at the time of purchase. The interest rate for CDs doesn't fluctuate.
The CD annuity was designed to eliminate that uncertainty for annuity purchasers who liked the guaranteed interest rate of a long-term CD but didn't like having the interest taxed every year. Like a CD, the interest rate of a CD annuity is guaranteed at least until the annuity's maturity. Unlike a CD, the interest earnings are not subject to taxation when earned. Therefore, if a 10-year CD and a 10-year CD annuity pay the same interest rate, the annuity will have a higher value upon maturity because its gain in value hasn't been taxed. Another attractive feature of any annuity is that if the owner dies, the annuity passes immediately to the named beneficiary, usually without having to wait for the probate process. CDs, on the other hand, are considered an asset and their value can be tied up in probate for months.
Even with the advantage of bypassing probate, the certainty of a long-term interest rate can be a mixed blessing. Moderate rates locked in during a period of market instability may look attractive when purchased, but lose their attraction in a bull market, when other investments are experiencing significantly greater returns. Annuities in their early years carry significant withdrawal penalties, up to 10 percent of the amount withdrawn, and withdrawals made before the owner reaches age 59-and-a-half incur an additional 10 percent tax penalty. CDs also impose significant penalties in early withdrawals, although there are generally no tax-related penalties associated with early CD withdrawals. Both instruments are extremely safe, but the FDIC insurance that covers CDs is generally more highly regarded than the state guarantee funds that insure annuities. In terms of historic reality, however, an annuity is as safe as an FDIC-insured CD.