Every smart retiree, including annuity owners, would like diversification in their income resources for retirement. And that means it may be unattractive to rely solely on annuities, if only because they are a long-term commitment in which your money is not readily accessible. A supplemental income resource to consider – especially for people interested in accumulating more money with little or no risk – is a bank-issued market linked certificate of deposit (MLCD).
These products provide three features you may find attractive – a fixed interest rate for a specified period of time, protection of your money because it is insured by the FDIC (up to $250,000), and the potential for a return higher than the guaranteed interest rate. . The latter feature comes courtesy of linking your investment to the rise in value of a stock, bond or commodity index. MLCD owners receive whichever is higher – the index gains, or the guaranteed interest rate. Your assets are not exposed to stock market volatility, though – you will get some interest or potentially more interest, and not lose money.
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. MLCDs have been growing in popularity because they offer the potential opportunity to beat low interest-rate returns. Many former investors have been fearful of the volatile stock market and have stayed away. Now, however, they realize that market-linked CDs could give them an opportunity to get market upside but with a principal-preserving guarantee.
MLCD Goal: Outperform 5-year Jumbo CDs
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 achieved that goal, although market returns are not guaranteed, and your results may be different.) Today, this means an MLCD endeavors to produce an annual return of 5 percent to 6 percent, compared to typical current jumbo CD returns of 2 percent-plus. And you don’t need $100,000 to buy one.
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 – so they are covered by the Federal Deposit Insurance Corporation (FDIC) like other bank deposits. This also allows banks to use MLCD proceeds to borrow from the Federal Reserve at a low rate and make loans at a higher rate. Banks can also make these transactions with CDs and jumbo CDs, but MLCDs pay have the potential to pay higher returns to consumers and, therefore, can attract more dollars.
Sold in $1,000 Denominations
A minimum-allowed purchase is usually $25,000, and MLCDs are sold in $1,000 denominations. The average MLCD purchase is about $60,000, according to Alternative Design, a San Diego-based MLCD distributor. The FDIC covers MLCDs up to $250,000 per bank by ownership category. (A single account without beneficiaries is insured up to this amount; a joint account without beneficiaries is covered up to $500,000.)
The shortest duration of most MLCDs is 5 ½ years; the longest 10 years. Most have about a seven-year maturity. Unlike an annuity, there is no surrender charge if you bail out early, but prematurely surrendered MLCDs are sold back to the issuing bank, which just pays you the current market value.
Depending on the MLCD issuer, the product is often linked to a basket of 10 stocks, 10 bonds or 10 sub-indices of a commodity index, such as the S&P® GSCI Commodities Index or various proprietary indexes, such as the Goldman Sachs Momentum Builder Capital ER 5 Index, an algorithm-managed index linked to 14 exchange-traded funds across seven asset classes.
Most MLCDs pay interest at maturity, although some also pay annually or monthly. Interest earned is taxable when it is credited to your account.
An MLCD has some drawbacks.
**** Depositors don’t typically receive all of the returns served up by the index the MLCD tracks – assuming, of course, returns are positive. Instead, the amount the CD pays is limited to the contractual participation rate, or a percentage of the return an index generates, (similar to one of the limitations on interest earned by fixed indexed annuities). Also, because of market volatility, MLCDs usually have a short marketing shelf life of only three weeks, sometimes even less. If you are interested but do not move quickly, the deal that piqued your interest vanishes.
In addition, MLCDs linked to a stock index pay no dividends, and there may be negative tax consequences as well. CD interest is taxed as ordinary income, rather than at the lower capital gain rate, as one-year-plus stock gains would be taxed.
The bottom line, though, is that MLCDs, in some perspectives, are one of the best deals a conservative investor can get without stock market exposure. Tim Harding, the chief marketing officer of Alternative Design, probably says it best. “These are very attractive for people for whom FDIC insurance matters but are frustrated by low rates and do not want to miss out on the market upside,” Harding says. In other words, it really may be attractive to you, warts notwithstanding.
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