Typically a multi-year guaranteed annuity and the term “CD annuity” are used interchangeably within marketing literature. While the description is accurate in describing conceptually how the product works, I feel it could be a little misleading to consumers.
An annuity is NOT a CD, it’s not related to a CD, and the two really shouldn’t be compared as much as they are. Later on I’ll get into some of what really makes them different. The differences may seem subtle to some but they are vitally important to understand.
First of all I'm going to refer to it as an MYGA from her on out.
Well, basically you agree to put your money in an account with an insurance company. Since you are giving to an insurance company, it’s a premium, not a deposit.
In exchange for the premium, the insurance company is willing to provide you with a guaranteed interest rate for whatever period of time you select. For our example, let’s use the 5-year MYGA, which is very common to find with most companies.
After checking around and looking at rates, right now, the best rate you could get from a company that you’d actually trust with your money (see life insurance company ratings) is right about 2.75%.
Wow…that really blew your hair back I know!
Yeah, nothing to write home about at the moment. The artificially low interest rate environment that has been manufactured by the fed over the last few years has put the squeeze on all insurance companies and life insurance companies in particular.
So all that means right now, if you gave company ‘x’ $100,000 they would in turn guarantee you 2.75% over a five year period if you left the money with them. It also means that you have a five year surrender schedule to contend with.
In other words, if you thought that you might need anything greater than 10% of your principal amount within the next five years, you should forgo a five year MYGA.
This is where MYGA’s begin to diverge from a CD.
If you withdraw more than 10% of the value of your annuity in any given contract year, you’d be subject to surrender charges. Unlike a CD penalty wich only costs you a portion of your interest, an MYGA will cost you a portion of your principal for a withdrawal greater than 10%.
Every MYGA has a surrender schedule, so that charge is not an arbitrary amount, it is defined within your contract. You’ll know exactly what they terms and schedule are before you give the insurance company any of your money.
A word of advice: Don’t sign your application or complete a transfer request until you understand the surrender schedule and the conditions/terms under which you can make a withdrawal.
Many people will say that because of these limitations or restrictions, MYGA’s are bad.
I say that all financial products, annuities included are amoral. They’re not good or bad. They’re just good for some people in some situations and bad for some people in other situations. Hope that makes sense?
If it works like a CD in that it guarantees a certain rate over a certain period of time, then what makes it really different or gives it any advantage?
Well, first and foremost, you should view an MYGA as an accumulation tool.
I know that thus far we’ve really only discussed the use of annuities as income distribution tool. That was the primary intention when annuities were first created.
The Big Shift
However, the fixed annuity, partial rate guarantee annuity and multi-year rate guarantee annuity came along and sort of shifted that paradigm a bit.
One major difference is that MYGA’s and all other types of annuity for that matter, are tax-deferred. The insurance company credits interest to your contract/policy and you are not required to pay taxes on the interest that’s earned–immediately.
As a matter of fact, you don’t have to pay taxes on the money until you start withdrawing it.
The Tax Man Cometh
In a CD, you are required to pay taxes on interest that’s earned regardless of whether you are actually withdrawing that interest or not. Over the years, we’ve found that most people dislike this part of owning a CD, particularly if they really don’t need the interest to pay for living expenses.
Many people have found that they prefer owning an annuity where they at least have more control over creating tax consequences for themselves.
You really can’t discount the tax deferred advantage that’s gained by using an MYGA.
Let’s compare an investment earning 7% (we can all dream, right?). In one column it’s taxable, in the other it’s tax-deferred.
Hopefully that paints a more a clear picture of using tax deferral to your advantage.
The other big difference
Now, the other major difference that can’t be overlooked when compareing CD’s to MYGA’s is that a CD does insure your deposit with the FDIC. There is no FDIC guarantee for your annuity premium.
The money you hand over to an insurance company is a premium and they are guaranteeing a return of your principal with interest, however, the guarantee is only as good as the company who issued it. That’s why I said earlier that you must be vigilant in selecting what company you give your money to.
One last thing that can make an MYGA very attractive to some people.
If you should die, the funds in your annuity will be transferred to your named beneficiary(s) and will completely avoid the probate process. While this may not be big deal to some folks, other people find it particularly appealing if they live in a very small town for example or they are extremely private.
Also, if a person has a large estate, probate fees can be quite costly and are typically based upon a percentage of the assets that must pass through probate.
To wrap it up, MYGA’s are definitely not the best thing since sliced bread but they do have their place in the financial planning world. And the fact that they are currently paying about 100bps (1%) more than a CD of the same maturity, should at least get them a second look.