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Using CDs in Retirement Planning

CDs, or Certificates of Deposit, Spare You The Risk But Won't Generate Much Growth

By David Fisher

(LifeWire) - Certificates of deposit pay interest to investors who agree to keep their money on deposit for a set period of time, which can range from a few months to several years.

CDs are regarded as a safe way to deploy cash that an investor doesn't need right away but doesn't want to put at risk. Most bank-issued CDs are insured up to $250,000 by the Federal Deposit Insurance Corp. through Dec. 31, 2009, when the insurance limit is scheduled to drop to $100,000.

CDs typically pay a fixed rate of interest, but more complicated variable-rate CDs are also available.

Bank Certificates of Deposit vs. Brokered CDs

Certificates of deposit can be purchased directly from the banks that issue them. They can also be purchased through brokerage firms or other types of "deposit brokers" that offer CDs from a broad spectrum of banks and other financial institutions.

Banks typically deduct an interest penalty on CDs that are cashed in before their due date. Brokered CDs can be sold before their maturity dates, but the sales prices will vary depending on the interest rate on the CDs and the market interest rate at the time.

Risks of Certificates of Deposit

The chief peril that most retirement investors should be wary of -- particularly younger investors -- is inflation. Although CDs typically pay higher interest rates than other types of bank deposits, such as savings accounts, their interest generally fails to outpace inflation over the long term.

Getting stuck with a low interest rate on a long-term CD while market interest rates are rising is another potential hazard. To mitigate that risk, most advisers recommend laddering a portfolio of CDs with a variety of maturity dates so a portion of the portfolio matures and becomes available for reinvestment at regular intervals.

Certificates of Deposit in a Portfolio

It's important to remember that CDs are more of a wealth-preservation tool than a wealth-building tool. They can be exceedingly useful for retirees who want capital preservation and a steady income stream. They are also excellent tools for investors who plan to spend a large amount of cash in the short term -- to buy a house, for example, or to pay for a college education.

For most retirement investors, though, CDs should be little more than ballast in a portfolio that will generate most of its real growth over time from riskier investments like stocks and bonds.

LifeWire, a part of The New York Times Company, provides original and syndicated online lifestyle content. David Fisher is a freelance writer based in Bend, Ore. In addition to 25 years as a writer and editor, he has worked as a professional financial adviser.

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