Brokered CDs Are Insured, Taking Away Credit Risks

Question: You have written about “brokered CDs” several times. I currently have $40,000 in six-month Treasury bills and would like to look into brokered CDs. Where do I get them, and is there a fee that would offset the interest difference between them and T-bills? E.P., by e-mail. Answer: Well, E.P., you’re not alone. After a recent column on how brokered CDs were providing a higher yield than both CDs and Treasury obligations, the mailbag was quickly filled with every variation on your question. So here are the basics: “A brokered CD is identical to a regular CD for insurance coverage,” Wayne Redmond told me. Redmond is vice president and manager of special products for Southwest Securities, a regional brokerage firm with offices in Texas and New Mexico. Specifically, Redmond says that brokered CDs are now insured to $250,000 per bank name for a joint account, just like regular CDs. That means your money is safe: Like a Treasury or bank CD, you have no credit risk. Redmond was quick to point out that there are a few differences between brokered CDs and regular bank CDs. First, all brokered CDs are “book entry” there is no certificate. You simply have an account. Second, while regular CDs can be redeemed early if you pay a penalty, brokered CDs can be redeemed without penalty but at market value. The market value will change with interest rates and could work to your advantage as well as your disadvantage. In this respect, a brokered CD is more like a Treasury obligation than a regular CD. Third, interest on a brokered CD is simple, not compounded. Instead of the daily compounding available on many regular CDs, you’ll receive interest at a simple annual rate. Interest earned on a multiyear CD will be deposited to another account where it may earn interest at a lower rate. This is not a concern for retirees who spend their interest, but it could be a material disadvantage for people who want to accumulate money. Fourth, a brokered CD has a “death put:” If the owner dies, the estate has the option to redeem the CD at par. This would be beneficial if yields had risen. But the seller also has the option to redeem at a higher value if yields have fallen. Fifth, while the brokering institution receives a commission, the bank, not the customer, pays it. As Redmond put it: “That means all your money is working. If you have a $10,000 CD, you’re getting interest on all $10,000, not interest on $10,000 less commission.” Where do you go to get brokered CDs? The largest dealers are the largest brokerage houses, places such as Merrill Lynch and Morgan Stanley Dean Witter. But brokered CDs are also available at smaller firms (like Southwest) and at some banks. You can, for instance, buy brokered CDs at Wells Fargo Bank. Are there any caveats? Yes. Most people forget that interest on U.S. Treasury obligations is not subject to state income taxes. This means a brokered CD buyer in a high-tax state could still do better, after taxes, with the purchase of a Treasury than with a brokered CD. One-year brokered CDs were recently being sold at a yield of 6.52 percent, an apparent advantage over the 6.28 percent yield of a one-year Treasury. A Texas resident who pays no state income tax, for example, would do well to buy the brokered CD. A New Mexico resident, however, could be subject to a state income tax rate up to 8.5 percent. This would nip 0.55 percent of the brokered CD yield, eliminating its advantage. Where can you get information on brokered CD yields? The best source I’ve found, updated regularly on the Internet, is Banxquote. In addition to individual CD listings, Banxquote offers a benchmarking table that compares average bank CDs in different regions with Treasuries and brokered CDs. Q: The Texas A & M; University system is considering making changes in the criteria it uses to keep funds on its approved list for its defined-contribution retirement plan. The changes would essentially eliminate all mutual funds except Fidelity funds and leave in its place a collection of variable annuities. The single objection to the other mutual fund companies, American Funds and Pioneer Funds, is their front-end sales charge. I think many people can successfully invest by themselves and that Fidelity should be an option. But those people who want a financial adviser should not be stuck with the higher fees of a variable annuity. What responsibility does the governing board, which decides these issues, have to ensure that all types of investment vehicles exist for the benefit of its constituents? D.F., Bryan, Texas. A: One thing you might do is suggest to the members of the governing board that they become familiar with a class-action suit against First Union Bank. Employees of an acquired bank are suing their employer because their investments were moved from a low-cost provider with a good track record to funds owned and managed by First Union. The suit maintains that the employees have been damaged. I think this is a bellwether lawsuit, one that should get the attention of all employers vis-a-vis their fiduciary responsibility for the overall cost and management of qualified plans. Finally, let’s compare the load mutual fund with a typical variable annuity. The American Funds group in Los Angeles sells only “A” shares the original front-end-loaded funds with commissions that average 5.33 percent. The commission is reduced for investors who make large investments or commit to make a large investment over a period of time. The average expense ratio of the fund family is 0.74 percent. The typical variable annuity has no front-end load commission but carries a very high expense ratio of about 2.1 percent. Worse, if you decide to change variable annuity providers, you face an early redemption penalty that can be significantly higher than the front-end load that American Funds charges. Buy the variable annuity and you face 2.1 percent expenses forever. Buy the load fund and you recover the front-end load in four years. After that, the net expenses of the mutual fund are lower and the variable annuity becomes more expensive. Long term, the variable annuity is very expensive. Let me give you an example. Suppose the American and a variable annuity firm both earned pre-expense returns of 10 percent a year and that you invested $10,000 in each. Where would you be at the end of 10 years? Even after taking the up-front commission hit of $533, the remaining $9,467 will grow to $22,950 in the American fund, while the variable annuity fund, which starts with the full $10,000, will grow to $21,370. That’s a 10-year difference of $1,580. Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: [email protected].