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Notes on Personal IRA CD Investing from a Long-time Reader - Part 2


Notes on Personal IRA CD Investing from a Long-time Reader - Part 2

This is the second of a two-part guest post on IRA CDs from a long-time reader and friend of the site, Charles Rechlin. Charles has many years of experience managing multiple IRA CDs at banks, credit unions and brokerage firms. I would like to thank Charles for sharing his experience on IRA CDs in these two articles. The first guest post focused on direct CDs that are held inside IRAs. This second post focuses on brokered CDs in IRAs.

Brokered CDs in IRA Accounts

by Charles Rechlin

Over the past two years, I’ve placed a significant portion of my accumulated IRA funds in traditional IRA accounts at Fidelity and Vanguard. This has greatly simplified the process of investing these tax-deferred assets in CDs.

The CDs offered via the trading platforms of these and other top-tier online brokers include the deposit obligations of a variety of banks across the US, both large and small, household names and little-known community institutions. (Credit unions do not offer brokered CDs.)

As a legal matter, these brokered CDs represent beneficial interests in one or more “master certificates” of individual banks held at the Depository Trust Company (DTC). Individual beneficial interests are created and maintained on the records of brokers, not on the records of the bank or DTC.

Nevertheless, the CDs are insured by the FDIC, as to principal and interest but not market premium, to the same extent as CDs and other deposit accounts opened directly at the bank. This requires, though, closely monitoring all CDs--brokered and direct--and other deposit accounts at each bank, which must be aggregated for insurance limit purposes. For example, my current portfolio includes several direct CIT Bank IRA CDs, a CIT Bank IRA savings account and a CIT Bank brokered CD in my IRA account at Fidelity; I have to consider them together to ensure I stay within the FDIC’s $250,000 insurance limit for IRA deposit accounts at a single bank.

Typically, the investor pays no commission charge on purchasing a new issue CD. There are relatively modest charges for purchasing or selling a CD in the secondary market.

Brokered CDs available for purchase include both “new issue” CDs—i.e., those sold directly by the bank, and usually priced at par—and “secondary market” CDs—i.e., outstanding CDs sold by other investors, usually priced at a premium or discount to par. They can be bought and sold through the online trading platforms, which, in the case of Fidelity and Vanguard, are user-friendly and involve no hard-copy paperwork, although both brokers do provide, online, confirmations of purchases and sales, and a standard CD disclosure statement.

Typically, the investor pays no commission charge on purchasing a new issue CD. There are relatively modest charges for purchasing or selling a CD in the secondary market.

The primary attraction of brokered CDs for me is convenience. I find it far easier to manage an IRA portfolio invested in brokered CDs than one invested in a disparate collection of direct CDs.

First of all, I can keep track of all the CDs in my portfolio at the broker on a single website. I don’t have to log onto individual bank sites to check account history, interest payments and upcoming maturities.

Further, although I invest in CDs with the intention of holding them until maturity, brokered CDs allow me the flexibility to change my mind quickly. If I see a CD offered with a particularly favorable rate and maturity, I can sell an existing CD holding via the online trading platform and redeploy the net proceeds in the more attractive CD (subject, of course, to the price I can obtain in the sale, which may involve gain or loss).

Above all, investing in brokered CDs through online IRA brokerage accounts vastly simplifies the process of managing maturing CDs and redeploying their balances.

Above all, investing in brokered CDs through online IRA brokerage accounts vastly simplifies the process of managing maturing CDs and redeploying their balances. On the maturity date, I can confirm the availability of maturing CD funds for trading, review the CDs currently being offered through the online broker and execute the purchase of one or more of those CDs with a few mouse clicks.

There are no hard-copy documents, no checks, no snail mail, no protracted delay, no sudden rate changes—and much reduced opportunity for error.

Of course, as discussed in prior blog postings on this site, brokered CDs pose certain disadvantages and risks not presented by direct CDs. Here are the main ones for me:

  • Interest paid on brokered CDs cannot be added back to the CD’s balance, and therefore isn’t compounded, as with direct CDs.
  • Unlike most direct CDs, brokered CDs do not provide rights of early withdrawal of principal, except upon death. Thus, to liquidate a brokered CD you must sell it, which exposes you to the risk of loss (which can be far larger than a typical direct CD early withdrawal penalty) in a market that is not known for being particularly liquid.
  • Because brokered CDs are held on behalf on the investor by a financial intermediary, they pose risks of loss not presented by direct CDs. These include inadequate record-keeping and misappropriation of assets, which are not covered by the FDIC and are only insured up to $500,000 per IRA account by the federal Securities Investors Protection Corporation. Also, because of the intermediation, it typically takes significantly longer to collect on FDIC insurance should a bank in your portfolio fail.
  • Brokered CDs usually carry lower rates of interest than direct CDs of the same maturity.

To some extent, this rate differential reflects the fact that banks selling new issues pay commissions to the brokers marketing them. The banks partially offset this expense by shaving the yields on the CDs.

In addition, because there’s a regular trading market in brokered CDs—albeit a “thin” one—I believe brokered CDs are much more sensitive than direct CDs to market fluctuations in the yields of competing fixed-income investments, particularly US Treasury Notes.

Brokered CDs usually carry lower rates of interest than direct CDs of the same maturity.

This rate sensitivity has been evident, for example, ever since the Federal Reserve increased the target Federal Funds rate last December. This move caused the Treasury yield curve to “flatten.” As a result, there has been a steep decline in the yields on new issue brokered CDs with maturities of three or more years. Although the posted rates on direct CDs having comparable maturities have also decreased, the decline has been nowhere near as dramatic.

I have to confess that the extent of the current rate differential between direct CDs and brokered CDs has, for the time being, interrupted my wholesale movement of IRA funds from maturing direct IRA CDs into to my Fidelity and Vanguard IRA accounts. For example, in the recent “rollover” transaction I described in Part 1, I opened a 3-year direct IRA CD at Ally to take advantage of a posted APY of 1.55%. At the time, a 3-year Ally new issue brokered CD was yielding only 1.25% at Fidelity.

So, uncertainty still surrounds investing my IRA assets in CDs. Nevertheless, although it’s a bit frustrating at times, at least it keeps things interesting, which I appreciate in my dotage.

Comments
Anonymous
Anonymous   |     |   Comment #1
Brokerage CD's usually pay interest every 6 months.  So for example, suppose you have a $150K New Issue (At Par Value) CD paying 2%.  You get $1,500 in interest in 6 months.   Where do you invest that $1,500?  

Also if you had to receive a RMD and suppose it amounted to $5,250,  how would you get that amount out of the $150K Brokerage CD.  I would think you would have to sell a portion of your CD to get the RMD and if perhaps if rates are up, then you might be undesirably in a situation of selling below par value.  Any ideas on how to make it easier to handle RMD's in Brokerage Accounts?  It is pretty simple with a bank or credit union.  They allow you to take the yearly RMD amount out of the CD without penalty.  
ChasR
ChasR   |     |   Comment #2
The fact that interest cannot be added back to the CD is a major negative for brokered CDs. It's more of a problem at Vanguard than at Fidelity, because the minimum CD investment at Vanguard is $10k, as opposed to $1k at Fidelity, so its harder to find a place to temporarily park paid interest.  Other reinvestment options include T-Bills and money market fund shares--hardly desirable from a yield standpoint.
As far as RMDs are concerned, I've scheduled maturities across all my CDs--direct and brokered--over the next five years to avoid issues.  I'm not relying on the ability to sell CDs to meet RMD requirements for the reason you state, although it's always an option if rates keep falling.
I guess that choosing between IRA CDs and brokered CDs is  a matter of picking your poison, which is another, starker way of saying what I wrote in the last paragraph.
Anonymous
Anonymous   |     |   Comment #3
I've bought Vanguard CDs for less than $10,000 . When I bought them (most recently in 2015) the $10,000 minimum applied _only_ to new issue CDs. Secondary market CDs had a $1000 minimum. Has Vanguard changed its policy, or is the $10,000 minimum something applicable to IRA CDs?
ChasR
ChasR   |     |   Comment #6
I stand corrected.  I dashed off that reply after double-checking the website fine print that says there's a $10k minimum "for CDs purchased through Vanguard Brokerage."  Based on the deals I can see displayed on the trading platform, it looks like that doesn't hold for secondary market trades.  I gravitate toward new issues because there are no commissions and because trades are at par so I never have to worry about avoiding paying a premium, not covered by FDIC insurance. That's a personal  preference others can take or leave. Sorry for creating confusion on the point.  
Anonymous
Anonymous   |     |   Comment #5
Thanks for your article and comments.  I am also experiencing and doing somewhat identical to what you are doing.  I have not reached RMD age yet, but I have also decided that drawing, before reinvesting, the funds yearly from a planned yearly maturing CD to meet the requirements of the RMD.  I am thinking one is going to need to plan ahead and schedule CD maturities so that enough funds are available each year to meet the RMD.  
paoli2
paoli2   |     |   Comment #7
The way we handle the brokerage RMDs is to make sure we have a CD maturing for each year which covers the entire RMD or we leave the interest which accumulates in their cash reserves all year and use that to make up for whatever we are lacking if the CD isn't enough.  Remember, the government does not dictate which account you have to take the total amount out of.  You just have to prove you took what was needed to be taxed out for that RMD year.  If you have enough in your cash reserves you can just withdraw that for the RMD but it must cover any and all IRAs.  So far it has worked fine for us doing it this way.
Anonymous
Anonymous   |     |   Comment #8
To make your earnings stretch - Another strategy on RMD:  Target first to take the max. allowable RMD amount from your lowest yielding IRA CD's.
bob
bob (anonymous)   |     |   Comment #4
Again, thoughtful commentary.  Much better than the other "contributing writer" for Ken's website, that reports old news once a week at length. My experience buying CDs from Fidelity is that there "share" of the interest is a lot more than 10 basis points.  Over many years of CD purchases I have estimated that the banks "shave from 40 basis points on CDs under three years in length.

I still can't get them to admit anything is shaved but of course, why would they offer them for nothing, and lose funds that might have gone to one of their own funds.

I look forward to your next article.
ChasR
ChasR   |     |   Comment #10
Before the Fed "raised" interest rates in December, there were a few brokered CD deals--3 to 5 years--in which banks offered yields higher than they were offering directly online.  No more. I just got this week's deal sheet from Incapital.  Its top 5-year CD deals yield 1.45% at GS Bank and Discover, 1.50% at Synchrony.  Thank you Janet Yellen.
Anonymous
Anonymous   |     |   Comment #9
IRAs are dead, the interest rates will stay low for decades or more.
"Yellen: No rate hike until uncertainty clears"
"Uncertainty", a new obstacle invented by FED to find any minute reason to stay of higher rates almost forever if you count the length of human life span. Now, including the global situation together with economic reason, they can postpone any rates hike now and in future, but the real reason is the national deficit, no nation on earth can carry such debt without consequences.
Anonymous
Anonymous   |     |   Comment #11
Thanks...I've been confused for a while...in brokerage IRA CD, why does one think that that is the same as one directly from a bank for FDIC?  "You don't own the CD."   I thought I read that it is an open question on FDIC coverage with a brokerage account for IRA CDs.  Any additional thoughts on that?
ChasR
ChasR   |     |   Comment #14
http://personal.fidelity.com/products/fixedincome/pdf/cddisclosure.pdf

The linked Fidelity Disclosure Statement contains an extensive discussion of how brokered CDs are treated under FDIC rules.  Basically, brokered CDs of a bank are considered the same as direct CDs of that bank.. As such, they are entitled to FDIC coverage, but must, in the case of the same depositor, be combined with the customer's direct deposits in the same category for insurance limit purposes. For IRAs, the direct IRA CDs of a particular bank owned by the customer are considered together with the brokered CDs of that bank owned by the customer in his or her IRA accounts at broker-dealers, with the combined total.covered up to $250k.  I don't think there's any question about this.
Anonymous
Anonymous   |     |   Comment #20
Thanks...going to the FDIC site it provides in part, "ask your broker to confirm that the deposit account records for its brokered CDs reflect the broker’s role as an agent for its clients (for instance, by titling the account “XYZ Brokerage, as Custodian for Clients”). That way, each client who owns the CD can qualify for up to at least $250,000 in deposit insurance. This coverage is generally referred to as “pass-through” insurance because it bypasses the broker and is calculated based on the ownership interests of the individual depositors. ..."
Anonymous
Anonymous   |     |   Comment #12
Generally speaking CDs are not deemed securities, however, brokered CDs are. 
jimbeau
jimbeau   |     |   Comment #13
Thanks for a great summary of brokered CD's.  This is particularly true of the risks involved.   Being dependent on Fidelity's record-keeping of these mashed-up CD's always was worrisome.   When pressed, they always trotted-out the SIPC insurance.  So, it would be prudent to keep your holdings to well under 500K at any one brokerage house. 

However, if anyone was going to do it correctly it'd be Fidelity and Vanguard.   Probably only an "end of times" scenario would cause them and the banks issuing the CD's to go belly-up at the same time.   But then, remember when Henry Paulson was running around with his hair on fire?  Granted, it was a small fire. 

As you pointed-out, the longer term brokered CD's aren't worth the bother.  Right now, you have to go ten years out to get 2.20% on a new issue CD at Fidelity.   NASA credit union is currently offering a 49 month CD with an APY of 2.20%.  For getting the same rate with a term that's 6 year's less, I'll putz with the IRA paperwork.




   

    
ChasR
ChasR   |     |   Comment #15
I started working in the New York financial district in 1971, and I remember very well the number of brokers--not to mention bars and restaurants--that went belly-up because of the "back office crisis" of the late 60s and early 70s.  SPIC was put in place as a result, and the SEC adopted rules to force brokers to keep their own assets totally separate from the assets of customers. With the massive proliferation of financial products since then, I've worried that those rules may be under pressure nowadays.  Keeping your assets at one b/d under $500k is a good idea.  I followed the practice for years, but decided to abandon this restriction at Fidelity and Vanguard earlier this year .  I have my fingers crossed.
Anonymous
Anonymous   |     |   Comment #16
Fidelity says they have coverage for amounts in excess of SPIC limits. I'll tell you this, if things go south I wouldn't even count on the SPIC. I've read that unlike the FDIC, SPIC takes quite a while to resolve claims. 
DCGuy
DCGuy (anonymous)   |     |   Comment #18
There are also quite a few pension funds that are having problems and the PBGC is not going to be able to rescue all of them.  I remembered the implementation of SIPC in 1970 to protect against brokerage insolvency.  I think the Madoff scandal brought out many claims with the SIPC.
ChasR
ChasR   |     |   Comment #23
Jimbeau: your comment about the 2.20% 10-year brokered CD rate on Fidelity has nudged me into mentioning something else. One item I didn’t cover in detail about IRA CDs versus brokered CDs is valuation—what you and others consider the true worth of your CDs.  I’ve deferred a detailed discussion on the subject—which is very important to me personally for estate planning purposes--until I do something specific on RMDs and how I’m planning to address my own RMD obligations   Anyway, one impact of having brokered CDs is that you find yourself with assets to which your broker assigns a “fair market value” (and which it reports to you and the IRS) based on trading market value, not just a “cost” value based on purchase price (par for new issue CDs).  Unless Janet Yellen is crowned Fed Chair for Life (with her big-money Wall Street backers, don’t count it out), it is fairly obvious to me that the holder of a 2.2% 10-year brokered CD can expect to see, at some point, a real hit to the value of his or her portfolio while holding it to maturity because of major fluctuations in market values over the CD’s life. I find that possibility very unappetizing.
Anonymous
Anonymous   |     |   Comment #24
This point you bring up has always been a little confusing to me.  If rates stay the same (low and leveled out) as they currently have for some time, below is what I think most likely is the case for a 10 year 2.2% brokerage IRA CD.  Every year the market value slightly increases on the CD because the market value increases a little each year because it is now at a shorter term but at the same 2.2% rate at par value.  So in effect in comparison to a direct IRA CD, you have to take out more than normal for your RMD because of this.  In other words, on the last year of maturity, the value will most likely be much more than the par value of the CD because it is now a 1 year term paying 2.2% at par so the market value would be more than par value and your RMD amount would be more because of this.  If marketable value for IRA brokerage CD's is used for calculating your RMD, would it not mean that you would be taking more out of your IRA CD portfolio sooner with brokerage IRA CD's in comparison to Direct IRA CD's?
ChasR
ChasR   |     |   Comment #26
That's an interesting point.  It sounds right, assuming rates stay about the same--although I don't know how dramatic the financial impact might be over the full term of a CD because, assuming you partially liquidate your CD to meet the RMD,  the fmv of the remaining brokered CD would decrease more rapidly than the fmv of the direct CD.  Or am I misinterpreting your point?
One thing I do know is that the financial  impact on my net worth (forgetting about RMD) if brokered CD rates were to start spiking in a stagflation scenario would be nasty.  That's what I lose sleep over.
jimbeau
jimbeau   |     |   Comment #27
I've got a similar issue with some TIPS.   The brokerage house uses the market value of TIPS when reporting to the IRS.   Due to the deflationary period that we had last year, some of the TIPS that were purchased actually lost principle value as calculated by the Treasury.   However, the market value of the TIPS went up!   Since I'm a few years away from taking RMD's, it didn't matter.  But if it was, the RMD would be based upon the higher market value and not the deflated principle value.  Talk about unappetizing!   Hopefully by the time RMD's are required, the interest rates will have gone up.   Supposedly, this should make the market value go down.  Assuming inflation rises along with interest rates, this would cause the market to be lower than the bond's inflation adjusted principle value.  Since I plan on holding the bonds to maturity that would actually lower the RMD. This was run across while building a spreadsheet to run some RMD scenarios.  Otherwise, I wouldn't have noticed it.
Anonymous
Anonymous   |     |   Comment #28
Take QCDs ant the pain does not exist
ChasR
ChasR   |     |   Comment #29
All these perceptive comments have forced my hand to reveal, more than I wanted to just now, what I'll be talking about in my piece on my personal RMD situation.  I'm not writing it until later this summer, but here's a "spoiler" alert--I've made advance arrangements (informal) to fund some charitable endowments out of my RMDs through the use of QCDs over time.:
Anonymous
Anonymous   |     |   Comment #30
And, "most" charities have failed to recognize the "marketing/business development" aspect of QCDs.  Some have been told that if "they" are not "marketing" QCDs for donations, they must not need my money!  Another thought is using QCDs for SPIAs for asset qualification for Medicaid/Medi-Cal LTC qualification...but almost all charities are further behind on that technique, too.  "It's only money!"  Look forward to your future insights!
ChasR
ChasR   |     |   Comment #31
Maybe the anemic "marketing" by charities of QCDs goes back to the annual tax uncertainty surrounding them before the law made the income exclusion permanent.  But, I agree. I've been surprised that charities don't make more of the subject on their websites and in their fund-raising literature.
Anonymous
Anonymous   |     |   Comment #32
This is #28 and 30.  "They are missing opportunities, big time!"  I say, "they don't know what they don't know" and will not move forward.

Good work on your part.
Anonymous
Anonymous   |     |   Comment #17
Charles, Thank you so much for this including your comments.  I have to take a look at Incapital, that is a site I was not aware of. 
Anonymous
Anonymous   |     |   Comment #19
IRAs are lost cause because the inflation and the costs are higher than the returns inside IRAs and then comes the tax man to collect the savings you have made over the years. A saving account or a CD can do better than today's IRAs.
Anonymous
Anonymous   |     |   Comment #22
"Costs are higher (for IRA CDs) and A saving account or a CD can do better than today's IRAs."  How/why?  The latter are after taxes and what costs if merely a Bank/CU CD...e.g. taxes be paid earlier which are being ignored in that latter part of statement. 

Therefore if CD rates for IRAs and non-IRAs are the substantially the same, why take the income earlier when taxes are assessed for converting to Roth?  Having an IRA allows for distribution timing to reflect what amount of taxes one wants to pay, (as noted before by others) IRAs are Bankruptcy protected,  and (as noted before by others) long term IRA CDs can usually have early distributions w/o penalties (especially if over 59 1/2 and for sure those over 70 1/2), etc.
Anonymous
Anonymous   |     |   Comment #21
Ken, the author gets intelligent comments and writes on very topical subjects.  Congratulations, he is a keeper!
Anonymous
Anonymous   |     |   Comment #25
Nice article. Thanks, Charles! (and thanks Ken for posting)