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.
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. 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.
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.