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Market-Linked CDs May be Worth Considering

By , with Annuity FYI

You may find an MLCD to be a good companion to your fixed annuity, which also has no market exposure and, reflecting the times, pays low interest rates.

Most adults know about bank certificates of deposit (CDs). These are time-limited accounts that grow your deposit at a set interest rate for a given amount of time, depending on your preferences. They are super-safe, guaranteed by the federal government, and super-easy to understand. The problem with them these  days is that the payout rate is a pathetic 1 percent or less.

What many people do not know is that some banks offer another type of CD – a market-linked CD (MLCD) that offers exposure to the stock market and thus has the potential to offer much higher returns. Principal is also guaranteed by the federal government, up to $250,000. Wise retirees, including annuity owners, like diversification in their income resources, and this may fit the bill, if only because the commitment to a MLCD is typically shorter than that of annuities with stock market exposure. Many guarantee a base return.

Most important, the so-called participation rate of a MLCD, also referred to as an equity-linked CD or market-indexed CD – is usually much higher than the index participation rates of conventional fixed indexed annuities (FIAs), often 80 percent-plus. A participation rate is the percentage of an annual market index gian actually pocketed. As MLCD terminology suggests, it’s essentially the banking industry’s version of a FIA.

There are some drawbacks. A bank can choose to redeem a MLCD before its maturity date. The account will have a call price,  which determines how much you earn if the MLCD is called. In this case, the payout may be smaller  than otherwise. In addition, gains are considered interest even though they are linked to the stock market, which means you have to pay ordinary income  taxes annually instead of the much lower long-term capital gain taxes paid by stock  investors. 

MLCDs have been growing in popularity because they offer the potential opportunity to beat extraordinarily low interest-rate returns. The stock market has been rising for years and may not fare as well moving forward, but exposure still makes sense for many because interest rates are now handily beaten  by the inflation rate. That means fixed income investors really earn no money. 

MLCDs, introduced by Chase Bank in 1987, are designed to outperform traditional five-year jumbo CDs – CDs with a minimum denomination of $100,000 — by 300 to 400 basis points annually. Historically, many have managed  to achieve this goal, and with a purchase of as little as $25,000.

MLCDs are sold by broker/dealers and by insurance-licensed professionals, but they are issued by banks. Among the major issuers are JP Morgan, Barclays, Goldman Sachs, BMP Paribas, Bank of America and Wells Fargo. They are in the MLCD business because MLCD assets officially count as deposits and so are covered by the Federal Deposit Insurance Corporation (FDIC), just like other bank deposits. This also provides banks an additional opportunity to borrow from the Federal Reserve at a low rate and make loans at a higher rate. 

The average MLCD purchase is about $60,000. Many MLCDs have a seven-year maturity, but a few are as short as 5 ½ years. 

The bottom line is that a MLCD may be the best deal a conservative investor can get. It’s particularly attractive to folks who like Federal Deposit Insurance Corporation – the best insurer in existence – but are frustrated by low rates and do not want to miss out on the market upside. Even with guaranteed income to fall back on, stock market exposure can be a negative because it’s accompanied  with some fees. But as the saying goes, no risk, no reward. Many people want an investment to at  least beat the  inflation rate  by a little.

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