Retirement Savings

Bank CD — Certificates of Deposit (CDs)

Also known as “time deposits,” certificates of deposit (CDs) are an insured bank product that pays a fixed rate of interest for a specified period of time (e.g., 18 months). These are favorites for retirement savings
among seniors because of their safety. Typical CD maturities range from seven days to five years, with higher rates
of return paid on CDs with longer maturities. A penalty is assessed if funds are withdrawn prior to maturity, resulting in the loss of a certain number of days of interest (the amount varies among financial institutions). If an early withdrawal penalty exceeds the interest earned, the difference will be deducted from an investor’s principal.

Many people think that CDs can only be purchased at banks. Many credit unions and full-service brokerage firms also sell federally insured CDs, thereby catering to seniors’ retirement savings needs. Investment firms purchase the CDs of banks nationwide in large blocks and sell them to investors in small denominations. The difference between their buying and selling price, called “the spread,” is how they make a profit. Since brokers shop the entire country for high yields, brokered CDs often pay more attractive rates than CDs at local banks. CDs can be redeemed prior to maturity, often without penalty, but, due to interest rate risk, the value of a brokered CD can be higher or lower than someone’s initial investment.

Another options for retirement savings, a relatively new type of CD, is the equity-indexed CD. Sold through both banks and brokers, these CDs base returns, in part, on appreciation of a stock market index like the Standard & Poor’s 500 (S&P 500). Many require a $5,000 initial investment ($2,000 for IRAs). Unfortunately, equity-indexed CDs rarely include the full appreciation potential of the S&P 500 because they exclude the portion derived from company dividends. Many also cap the maximum growth rate, which further reduces upside potential. As a result, most financial advisors suggest avoiding these CDs and buying regular CDs for income and a stock index fund for capital growth.

Money Market Mutual Funds

Money market mutual funds are a type of mutual fund consisting of high quality, short-term debt instruments such as Treasury bills and short term corporate IOUs. Like all mutual funds, money market mutual fund (MMMF) portfolios are professionally managed and a management fee is charged against fund assets to cover this expense. MMMFs offer market-based rates and are quick to respond to changing conditions because the average maturity of securities in their portfolio is 90 days or less. The minimum initial deposit is set by individual investment firms and can range from $250 to $25,000. MMMFs can be purchased directly from investment companies or with the assistance of financial advisors. The factor that makes these popular for retirement savings compared to CDs is that money market funds are totally liquid, just like a checking account.

Unlike bank-sponsored money market deposit accounts (MMDAs), there is no FDIC insurance if a MMMF fails to maintain a $1 share price. Failures have happened very infrequently in the last 20 years, however, and most investment firms have shored up MMMF prices with other company assets to avoid a loss of principal by investors. Limited check writing is generally available on MMMFs with a minimum amount (e.g., $250) per check. Investors seeking both safety of principal and tax advantages can select tax-exempt MMMFs that include short-term securities issued by state and local governments. Other conservative choices are MMMFs that invest solely in Treasury bills and/or Treasuries plus debt of federal government agencies.

Guaranteed Investment Contracts

Called GICs for short, guaranteed investment contracts are fixed-income contracts issued by insurance companies as an investment option for 401(k) retirement plans. Another, more commonly used, name for GICs is “stable value funds.” Like CDs, only tax-deferred, GICs pay a fixed-interest rate for a specified period of time (e.g. 3 to 5 years). Because they are backed by an insurance company, and not the federal government, GICs generally pay a higher return than CDs and other cash investments. Their return is lower than stocks, however, leading to criticism that they are inappropriate for long-term financial goals like retirement. These are popular for retirement savings among the most conservative investors.