What’s an Equity Linked CD?
An equity linked CD is a certificate of deposit issued by a bank where the rate of return is tied to a particular stock index, like the S&P 500® or DJIA®. Equity linked CDs are insured by the FDIC to the maximum amount permitted by law, so your principal is secure.
If Equity Linked CDs are Not Annuities, Why Are They Featured on Annuity FYI
Equity linked CDs have benefits including protection of principal, ability to participate in market upside, and low cost. As such even though equity linked CDs are not annuities, we think that they can be an exceptional component to one’s retirement portfolio.
What are the Similarities and Differences between Equity Linked CDs and Fixed Rate of Return CDs?
An equity linked CD is very similar to a traditional fixed rate of return CD. Both guarantee your principal if held to maturity, and are FDIC insured. Both require you to commit your money for a specified time frame before withdrawal and as such are illiquid – sometimes early withdrawals are prohibited entirely, other times they are permitted but an early withdrawal fee is imposed. Both allow for early withdrawal without penalty in the event of the death of the account holder. There are important differences between the two types of CDs, however:
Rate of Return
Traditional fixed rate of return CDs pay a guaranteed rate of return on a regular basis, depending on how long you commit your money. For example, as of January 31, 2010, you can find 5-year fixed rate of return CDs that guarantee 3% interest per year. Equity linked CDs, however, link the rate of return to a given market index, such as the S&P500®, rather than guaranteeing a fixed rate. This is attractive to many investors who believe that the corresponding stock market index may exceed such returns in that same 5-year timeframe. Equity linked CDs afford the safety of a traditional CD (your principal is insured, even if the stock market declines) with the ability to participate in stock market gains.
Timing of Return
Traditional fixed rate of return CDs pay out interest according to a set schedule. For example, a 5-year CD typically pays interest at the end of each year. Equity linked CDs pay the return at the end of the investment period, rather than annually.
What to Watch Out For
There are a few complexities with equity linked CDs about which you should be aware:
Some equity linked CDs have caps on how much you can earn. The cap rate is the annual maximum percentage increase allowed. For example, if the chosen market index increases 35% over the investment period, and the contract has a 14% cap, your return will be limited to 14%. Annuity FYI recommends a simple rule – don’t buy an equity linked CD with a cap. It’s that simple.
The participation rate, also known as the index rate, is the percentage increase in the index by which a contract will grow. For example, suppose the participation rate on an equity linked CD is 75% and based on the S&P 500®, and the S&P 500® increases 10% for the year. The equity linked CD would be credited with 7.5% (75% of the 10% gain). Annuity FYI recommends a simple rule – don’t buy an equity linked CD with a participation rate of less than 90%. It’s that simple.
Index Credit Period
You would think that measuring the return of a market index in order to calculate the return on an equity linked CD would be straightforward – take the index on the day you invested in the CD, on the day when the CD matures, and then calculate the return. However, banks sometime use confusing formulas to calculate the return, such as averaging returns over time. You will see terms like “monthly average” and “annual point-to-point with annual reset” and other confusing terms (take a look at our section on fixed indexed annuities for examples and you’ll see how confusing it is). These formulas often give you a rate of return less than the index in an environment where the market is steadily increasing. Our advice? Only consider equity linked CD where the index crediting method is “term point-to-point.”
Even though with an equity linked CD you are credited with the return at the maturity date, you may have to pay taxes on an assumed or calculated return every year.