With bank savings accounts earning pennies in interest, and even long-term certificate of deposit rates averaging less than one percent, it can cause a squeeze in the household finances. One result is some people go on yield safaris, looking for bigger interest game. While there is nothing wrong with trying for higher returns, the concern is that the potential for loss is sometimes overlooked.
A decade and a half ago auction rate securities and mortgage bond tranches were sold as low risk, liquid alternatives during a period when bank rates were falling. However, auction rate securities largely became illiquid and many of the “AAA” bonds were reclassified as junk or in default in 2008.
This time around some savers were buying packages of small business debt – but the impact of SARS-CoV-2 is causing small businesses to fail. Others are buying dividend paying stocks – often a sound move, but even companies like Ford creased their dividend in 2020. The more adventurous try covered call option writing, where you collect a fee for agreeing to sell a stock you own at a given price. It works well when the stock price is steady; however, all the option fees put together cannot overcome a big drop – like Exxon Mobil share price falling roughly in half in 2020.
If you’re a saver looking for a place that pays higher interest than the bank, but still protects your principal and the interest you’ve earned from market loss, the alternative is pretty much coming down to fixed annuities. Although a fixed annuity is not FDIC insured, fixed annuity carriers have an excellent record of protection in both good and bad financial times. There are two main types.
A fixed rate annuity pays a locked-in interest rate for a specified number of years – anywhere from one up to ten. A fixed index annuity pays interest based on the performance of an independent index, usually linked to the stock market. Which is better? It depends.
With a fixed rate annuity you know what you’re getting. With a fixed index annuity if the index goes down you won’t earn any interest for that year (but you won’t lose what you have). However, the fixed index annuity often offers the potential for considerably more interest, so if the good years offset the bad they could pay much more interest. It ultimately comes down to whether you’re okay with seeing a zero in a given year.
Fixed annuities have penalties for early withdrawal called surrender penalties. For fixed rate annuities with multiple year interest guarantees the penalty period usually matches the guarantee period. Fixed index annuity penalty periods are usually for five to ten years. The early penalties are much higher than those imposed on certificates of deposit – so you shouldn’t buy the annuity if you think you’ll need to cash it in early – but you need to look at the entire picture. If your choice is between a CD paying 0.75% and a fixed rate annuity paying 2.5% that has a 6% penalty, you are money ahead with the annuity after four years, even after cashing it in.
This is a very tough time for savers, and it doesn’t look like yields will be going up anytime soon. Even so, this isn’t the time to quit the bank and start hunting exotic yield beasts that could come back to bite you. It is a good time to consider moving some of that money to the protected sanctuary of fixed annuities.
For educational purposes only. Does not provide investment, tax or legal advice. Information believed accurate, but is not warranted. Not a solicitation to buy or sell any security. Past performance is not an indication of future results. Both investments and fixed annuities involve certain risks; a consumer should consult with their advisor. Fixed annuities are not bank instruments and are not insured by FDIC.
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