Structured CDs: Buyer Beware!

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. 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? 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 (emphasis ours): “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:

  • “[O]f 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.”
  • “[M]arket-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.

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.