Most investors are familiar with Certificates of Deposit (CDs). You purchase one, and the bank pays you a bit of interest on it, plus your principal back. They don’t yield much, but they’re nearly as dependable as it gets. As such, CDs can often serve as sensible tools for offsetting the risk inherent to pursuing higher expected returns in the stock market.
Beware of “Structured CDs”
Unfortunately, Wall Street’s product pushers have figured out a way to swipe the name from this traditional household workhorse and turn it into a monster money-maker … for themselves, that is. We’re talking about “structured” or “market-linked” CDs. The name may seem familiar, but the rules of engagement are quite a bit different.
A recent Wall Street Journal article, “Wall Street Re-Engineers the CD – and Returns Suffer,” exposed the ways that big banks are peddling these products. It starts with a tempting pitch that goes something like this: As long as you hold the product to maturity, your principal is returned. If the stock market goes up (as defined by whatever market “basket” the providers happen to choose) you also receive a percentage of the increase. At a glance, what’s not to like about this sort of “heads you win, tails you don’t lose” appeal?
The Fine Print
Unfortunately, there are usually plenty of traps lurking in the fine print. Positive returns are typically capped to single-digit annual percentages, while negative returns can plummet much more steeply before they’ll no longer impact your end returns. And the fees can run into multiple percentage points of the structured CD’s face value.
The WSJ article reports: “The adviser who actually sells the [structured] CD, for example, can get commissions of up to 3% of the CD’s value, according to information sent to brokers reviewed by the Journal. ‘Banks have to be delighted with these structured products,’ said Steve Swidler, a finance professor at Auburn University. ‘There’s virtually no risk to them, and [the banks] sit back and rake in fees.’” It may be easy enough to overlook the significance of these costs and imbalances, especially if you’ve decided that you’re okay with paying extra for the promise that you will not lose your nest egg. But in fulfilling their role as a safe investment, structured CDs can be more than a little skewed in favor of the big banks. From the WSJ article:
“Of the 118 structured CDs that were issued at least three years ago, only one-quarter posted returns better than those of an average five-year conventional CD. And roughly one-quarter produced no returns at all as of June 2016.”
“Market-linked CDs issued since 2010 by Bank of the West … revealed a similar pattern. Sixty-two percent produced returns lower than an investor would have received from a five-year conventional CD, while almost a quarter have yet to pay any return at all.”
Given how many other far less complex and costly ways there are to expect similar results, why start with an uphill climb? The WSJ article noted how one investor, a 79-year-old widow, was shocked to see her $100,000 investment immediately drop to $95,712 after incurring upfront fees. The fees had been disclosed in the 266-page description that came with her purchase, but she hadn’t read it. Would you have?
“This was not a CD as I know a CD,” she complained.
No Compounding or Reinvestment
Here’s a key detail many investors miss: unlike traditional CDs, structured CDs don’t allow your earnings to compound over time. You won’t have the opportunity to reinvest any interest as it accrues. Instead, any gains or returns are credited only once—at maturity. In short, you’re stuck waiting until the very end to find out what, if anything, the investment has earned for you.
What Is “Mandatory Redemption”?
There’s another twist to be aware of: the dreaded “mandatory redemption.” This means that even though the bank isn’t required to buy back your structured CD before maturity, it can unilaterally decide to call it in early—often with little warning. If this happens, the payout you receive may be far less than you expected, and to make matters worse, you could be left waiting months (or even years) before you see your money. In other words, just when you think you’ve settled in for the ride, the bank can boot you off the bus—and you might not even get your full fare back.
Early Withdrawal: A Costly Surprise
Structured CDs come with strings attached—especially when it comes to tapping your money early. Unlike garden-variety CDs at your neighborhood bank (which sometimes allow for an early exit with a modest interest penalty), structured CDs take the concept of “locked in” to a whole new level.
If you find yourself needing to cash out before maturity, be prepared for a set of hurdles that would make even an Olympian wince. Typically, you can’t just walk in and collect your money. There may not even be an option for an early redemption at all. If you try to sell before the structured CD matures, your only route is usually through the thinly traded secondary market—assuming you can find a buyer at all. And the price you get? Often less than what you initially put in, sometimes much less.
On top of this, additional layers of costs lurk beneath the surface—think hefty transaction fees and the unfortunate possibility of getting caught out by a drop in your CD’s market value.
To make matters even more precarious, the issuing bank isn’t obliged to buy your CD back from you. Yet, paradoxically, they can “call” or redeem the product early on their own terms—sometimes before you’ve received the benefit you expected. If that happens, you might wait months or even years to get your payout, with no guarantee it matches your original hopes.
Can You Get Out Early? The Catch With Selling Structured CDs
Thinking you might change your mind or need to cash out your structured CD before it matures? Don’t count on it being easy, or painless for your portfolio. While you technically can attempt to sell a structured CD prior to its maturity date, here’s where the fine print bites again.
First, most financial institutions have no obligation whatsoever to buy your CD back. If you want out early, you’re likely facing the Wild West of the secondary market—if there’s even a buyer out there. And just like trying to sell a limited-edition Beanie Baby at your neighbor’s garage sale, don’t expect to get face value for your troubles.
Even if you do manage to find a buyer, you’re at the mercy of whatever the going market price happens to be, which could easily mean walking away with less than you originally invested. Adding insult to injury, transaction fees can take yet another chunk out of your proceeds, making early liquidation more of a lose-lose than a quick escape.
All told, if you’re considering a structured CD, plan to stay buckled in until maturity—or risk significant penalties and unintended losses if you try to jump ship early.
What About Taxes?
Now, before you consider dipping a toe into the structured CD waters, let’s talk about something that often sneaks up on investors: taxes. With traditional CDs, you generally know the drill—interest gets reported as income each year. Structured CDs, on the other hand, can introduce a few extra wrinkles.
First, you’re typically on the hook to pay taxes on any gains credited to your CD each year—even if you can’t actually touch a dime of it until the CD matures. That means you could find yourself paying out-of-pocket for taxes on earnings you haven’t yet received.
Worse, don’t expect any sort of break just because the returns are tied to market performance. The IRS doesn’t treat these earnings as capital gains or qualified dividends (which get preferential rates). Instead, structured CD returns are taxed as ordinary income—the same way your paycheck is taxed. So, even if the stock market surges and your structured CD manages to eke out some gains, Uncle Sam will want his cut at your highest marginal rate. Not exactly an investor-friendly twist.
Tax Treatment: Less Than Ideal
Taxes are another sneaky piece of the structured CD puzzle. You might assume that, since your returns may be tied to stock market performance, any potential gains would be taxed like long-term capital gains or qualified dividends. Sadly, that’s not the case.
Instead, all earnings from structured CDs are taxed as ordinary income—often at a much higher rate than capital gains or dividends. To add insult to injury, you’ll owe tax on earnings each year as they accrue, even though you won’t see a dime in your account until the CD matures. Uncle Sam wants his cut before you ever touch the money, making the tax situation even less attractive for investors hoping for a tax-efficient strategy.
Our preferred approach?
Insist on transparent costs and clear, understandable performance reports. Be highly skeptical of one-off products that promise both higher returns and lower risks. There are almost always expensive tricks and traps lurking in the fine print. Focus instead on investing according to a well-structured plan that positions your total portfolio to reflect your long-term goals and risk tolerances. These essential concepts may not be fancy or new-fangled, but unlike those allegedly higher returns that a structured or market-based CD is supposed to deliver, they’re far more likely to see you through to your own end goals.