What are the Pros and Cons of Structured CDs?

An investment product that's full of potential and pitfalls.

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With interest rates still historically low, you may be searching for ways to boost the return on your cash savings.

Certificates of deposit are popular among people who don’t want to risk losing their money in the stock market, but want to get a little bit of a higher return than a standard savings account. With CDs, you deposit your money into an account for a pre-determined period, and earn interest over time—longer terms offering higher interest rates.

But even CDs don’t offer the same income potential as investing in the stock market, and that’s why some financial institutions offer products called “structured CDs” that promise the potential for equity-like returns with no risk of losing your money.

The allure of structured CDs stems from the fact that they allow an investor to get returns designed to mirror the stock market without the risk of losing principal. Thus, they are often marketed as “risk-free” investments. But there are some pitfalls and complexities to structured CDs that make them less than ideal for many investors.

Structured CD Basics

First, it’s a good idea to stop referring to these products as CDs, as they don’t really resemble the standard certificate of deposits that you can get from your bank. A standard CD is simple, with a fixed return, no costs, and terms that most of us can understand.

A structured CD, on the other hands, is complicated and can often come with fees and commissions that impact what you earn. It is essentially a derivative product in which the performance of the CD is tied to an underlying investment, such as a stock market index. For example, you may be able to purchase a CD designed perform in similar fashion to the S&P 500. For this reason, you can make more money off a structured CD than a standard CD. But, you can also end up with zero return if the markets go down.

You Can Lose Money on a Structured CD

Most structured CDs are set up so that your return can’t go below zero if the markets dip into negative territory. But, you still may end up losing money because of the fees associated with the product. Let’s say you place $10,000 in a structured CD, but the stock market does poorly during that time. The principal of your investment is supposed to be protected, but once you factor in fees and commissions (usually something like 3%) you may find that you have less at the end of the term.

The idea behind most traditional CDs is that you are willing to tie up your money for a certain length of time in order to achieve a certain return. If you choose to withdraw your money before a term is up, you must pay a penalty, usually amounting to several months of interest.

With structured CDs, the penalties for early withdrawal are more severe and you may not be permitted to withdraw money before maturity at all. That’s because structured CDs are set up so that you only get paid at the end of the maturity date. You can sell your CD to someone else before the maturity date, but you will receive the market price for your CD, which may be less than your principal. It’s also important to note that the financial institution that sold you the CD has no obligation to buy the CD back, and thus you may be forced to try and sell it on the secondary market, if one exists. If you do succeed in selling the CD, there will likely be hefty fees that cut further into your return.

Ironically, while a financial institution is under no obligation to buy back your CD, it reserves the right to call it back. This so-called “mandatory redemption” can happen at any time, even if you have not received the full amount you thought you would get from the CD. Moreover, whatever funds you do get following a mandatory redemption may not be provided to you for months or even years.

Returns Can Be Capped

Despite the fact that structured CDs promise to offer returns similar to stock market indices, the banks that offer these products will place a limit on what you can actually earn. The financial institution will tell you up front that no matter how well an index performs, they will only pay out up to a specific total.

For example, Goldman Sachs in 2014 began selling a structured CD with performance based on the Dow Jones Industrial Average and due to mature in 2021. The terms of the CD show that upon maturity, Goldman Sachs would return the CD principal along with $1,000 times the return of the index during that period. So for example, if the DJIA rose 20% between 2014 and 2021, the investor would get $200 on top of the original principal. (The $200 labeled as the “supplemental amount.”) However, Goldman Sachs has set a maximum supplemental amount at between $620 and $680. Thus, if the markets did very well and rose more than 68 percent during that time, the investor might not receive the full benefit.

In addition, the returns on structured CDs are not compounded like in traditional CDs or other investments. There is no way to re-invest earnings to boost overall returns; the investor only sees their return when the CD matures.

Tax Implications

Structured CDs can be very problematic for investors from a taxation standpoint. It’s important to know that you must pay tax on the earnings of the CD each year, even though you will not receive any money until the maturity date. Moreover, even though returns on structured CDs may be based on the performance of the stock market, they are taxed at the rate of ordinary income, not at the lower rate assigned to capital gains and dividends.

The Bottom Line

Structured CDs can be a possible option for those investors who don’t want to risk big losses in the stock market but want the potential for stock market-like returns. But structured CDs are complex, inflexible, and may end up costing the investor in the long run.

For most investors looking for strong returns without the risk of losing principal, there are other, better options including dividends stocks, bonds, and traditional CDs. If you do choose to purchase a structured CD, be sure to read all of the terms and conditions thoroughly beforehand.