I was speaking to a representative at Wells Fargo today when she pushed their Market Linked Certificate of Deposit (MLCD). To be honest, I knew nothing about it so I did a little research.
How It Works
Basically, Market Linked CDs are like traditional CDs but instead of a fixed interest rate, the CD’s returns can be tied to a major index like the Dow Jones Industrial Average of the S&P 500. The return can also be linked to commodity prices, currencies, and even benchmarks like the Consumer Price Index (CPI) so this allows retail investors to invest in areas that are otherwise too complicated to get into.
The interesting thing to note is that these CDs are backed by the FDIC so they are insured. On top of that, it is set up so if the benchmark (or index) falls by the maturity date, you still get your principal back.
Advantages of Market Linked CDs
These MLCDs seem to be a marriage between the stock market with the traditional CDs that we are familiar with. The advantages are as follows:
- FDIC Insurance – Yup the principal is insured to a maximum of $250,000 this year and up to $100,000 thereafter, just like any other savings accounts or CDs.
- Unlike the stock market, you are guaranteed to get your principal back as long as you don’t withdraw before the maturity date
- Keeps you from buying and selling since a CD gives you the “locked-up” effect that traditional CDs provide (lack of liquidity can sometimes be a good thing)
MLCDs sound almost too good to be true since it’s got all the upside rewards but none of the downside risks. Of course, once you look into it further, it’s not perfect.
- Early Withdrawal Penalties - Even though the principal is guaranteed if you hold it to maturity, this is not the case for early withdrawals. Therefore, it might be possible to have a huge withdrawal penalty if you need the money before maturity.
- Bad Tax Rates – Your returns are considered interests so even though it might be from the performance of a stock market, it doesn’t qualify for the long term tax rate of 15%.
- Ugly Tax Treatment – Furthermore, there’s a quirky rule that says you have to report returns as income every year you own this CD (if held in a taxable account). So while you might not even receive anything until maturity, you have to pay taxes on some return (the return is based on a traditional CD that the bank deems comparable).
- Possible Upper Limit – Some MLCDs have a cap on the high end that limits the returns, so the comparable index returning 100% doesn’t mean you will get a 100% return in your MLCD investment.
- Dividend Reinvestment – A big chunk of market returns are actually provided by the dividends that the company pays. Investing in MLCDs that track the index will not benefit from this.
What I Think of MLCDs
The tax implications really turns me off so this option for taxable accounts are automatically out of the question. It’s not just the higher tax rate, but needing to pay taxes on money that I don’t even have yet really turns me off.
As for IRAs, the guarantee of no lost of principal is really great but as I have a very long time horizon, strictly investing in index funds is a much simpler strategy than investing in MLCDs due to the fact that I can’t imagine the S&P 500 being much lower than it is now in something like 35 years in the future (Remember that even if the index is lower, I would’ve reaped the benefits of reinvesting the dividends).
Who could really benefit from something like this are people who will retire in the next 10 years. These people might not have the time horizon to wait for the stock market to come back, so giving up the dividends might be worth it to lower the risk of possibly another market crash before retirement.
Have you thought about this type of investments and do you own any? Will you consider it? What do you think?
Update: My dad sent me an email with a good way to take advantage of this. If the MLCDs have short terms (like 3 to 6 months), then it’s a great way to make money since you can take advantage of the volatility and only pocket the interests when the benchmark goes up.. This is almost like free money but then I checked a bunch of offerings and they all have 3 year terms at a minimum. No free lunch this time.
- E*TRADE IRA - Official Site