Structured CDs: Questionable At Best

What exactly is a Structured Certificate of Deposit? First of all, we should define a Certificate of Deposit or CD. Most people own CDs but may not exactly know what they are. CDs are generally defined as "products" created by banks, credit unions, and similar entities. Essentially, the bank takes your cash, and in return pays you back at a posted interest rate for a set time period. At the end of the time period, your cash is returned to you. The financial entity's business model entails its use of your cash for its investments that are supposed to return a lot more than what the bank pays you. The longer you agree to leave your money with them, the more they will pay you. CDs are FDIC insured and are guaranteed by the government. These investments are for people who do not want to lose principal. The problem is the interest payments are really low. That is where the creative financial institution and creative sales-person comes into the picture, for better or for worse.

Hence the creation of the structured CD product. The selling point for this product is stock market returns with CD safety. Sound too good to be true? None the less, that is how they are often marketed. Technically, these products should not be called CDs. The resemblance is minimal. As discussed above, a CD is pretty basic. Set interest and terms, and most importantly, no fees! However, structured CDs are far from basic. Moreover, they do charge fees and/or commissions. This can have a negative impact on purported returns.

A Structured CD should be classified as a "derivative". A derivative is defined as a product whose value is based on a pre-determined underlying asset, usually a commodity or security. In the structured CD context, its almost always based on an index such as the S&P 500 or the Dow Jones Industrial Average. As such a Structured CD can make you more money than a standard CD, but you can also lose money. Though most Structured CDs are set up so your investment can't go below your principal, you can lose money vis a vie the fees/commissions you pay.

The concept of the traditional CD is that if you withdraw early, there is a penalty that can impact your return. However, with a structured CD, the penalties for such premature withdrawal are greater and in some instances, the investment is locked up completely and there is no access until the term is concluded. Potentially an investor could seek out a secondary market to rid themselves of a Structured CD. Assuming a buyer can be found, the price would be at a steep discount. The financial entity that sold you the product is under no duty to buy it back. Conversely, that same entity retains the option to call or buyback a Structured CD if it is not a profitable venture for them. To make things worse, the buyback may happen over time in staggered payments.

Another negative aspect is the general rule that the financial entity will always act in its best interest over that of the purchaser of the product. In other words, your gains, if the underlying index does well, will be capped. The salesperson will tout the sharing of gains with the stock market, but the simple fact is that the structure of the product limits how much the investor can make. Furthermore, the returns on these products do not compound the way an old-fashioned CD would. There is no option to re-invest the payments. The gain only materializes at maturity, which brings us to the next problem: taxation of these products. Structured CD investors must pay tax every calendar year there is an earning. So on a five-year term, you pay taxes along the way but never take possession of those returns. Moreover, your gains will be taxed as ordinary income, not the lower capital gains rate. This is true even if the underlying index is entirely based on stock market gains.

With these products, the investor gets extra fees, risks associated with the stock market, but not the unlimited upside of the stock market. The alleged added returns are not that great and the taxation is not favorable for the risk incurred. Except for some limited situations, Structured CDs are generally just not a good idea for most investors.