TSP Hardship Withdrawal Costs

(Gubmints Note:  This is part of a multi-part post, which will also extoll the virtues of Structued CDs and Structured Notes, and provide strategies on how to use them.  At the time of this writing I hold an S&P Index-linked Structured CD in a Retirement Account).

With bond and bank CD rates near zero, investors have been scrounging everywhere they can to find respectable yields (Note, if you’re a Govvie the best place to park cash is the TSP’s G Fund– It gives you returns of long-term bonds with the liquidity of a Money Market Fund.  You can’t find a product like this anywhere).  Folks without a G Fund generating their current income may resort to chasing yields in complex products like Structured CDs.
A Structured CD allows you to purchase participation in an index (like S&P 500 or DJIA, but it could be any index) up to a participation ‘cap’.  Your initial investment value is guaranteed by FDIC insurance (which, per Dodd-Frank, is up to $250,000 per bank/instutution).  No downside with huge potential upside?  Sounds too good to be true!
Here’s Ten Reasons Structured CDs and Structured Notes Suck:
1 – It could require as much as $25,000 for a minimum investment.  For most wage slaves, this is a ton of cash to lock-up for 5 years.

 

2 – They have Huge Front End Loads, ranging from 3%
to 8%.

 

3 – They are not required to register with the SECA 20-page prospectus written in 6-point font that’s not required to file with the SEC?  I’m intrigued, please tell me more!

 

4 – Some Structured CDs track some very archane indices with little tracking data available.  Here’s some examples of the custom indicies available (BRICs and Cherry-Picked indicies):

 

5 – Even if the Index is well known, payout formulas can be enormously complex

  • Some have Point-to-Point (start/finish) index values to determine your return.  This is pretty simple to figure out.
  •  Some have a Point-to-Point rate of return, with a Cap on your maximum return.
  •  Others can have bizarre products like ‘Rate Steepeners’ or perform math tricks like compute the index’s AVERAGE value over the holding period to compute your rate of return.  Here’s an example from Banco Popular.  Their product takes the arithmetic average of the DJIA over 60 months, then multiplies by 1.25, but has a maximum value of 1.4x total return:
The following method is used to compute interest: First, the Stock Market value of the S&P 500 Index is obtained on the business day immediately prior to the date of the opening of the account (Initial Index Value). From that moment on, the S&P 500 Index is recorded and maintained, from the date of the final Stock Market business day of each month during the term of the account (End of Month Index Value). At maturity, the averages of the End of Month Index Values during the term are computed by adding the End of Month Values and dividing that sum by 60 to determine the Average Index Value. Then the percentage increase of the S&P 500 Index, if any, is computed by taking the Average Index Value and subtracting the Initial Index Value and dividing the result by the Initial Index Value. If the Average Index Value is equal or less than the Initial Index Value, no interest will be paid.
If deposits are made or accounts opened using non-cash items (i.e. checks), interest begins to accrue on the business day on which the transaction takes place.
The interest payable is 1.25 (125%) of the percentage increase in the S&P 500 to a maximum of 40%, with no guarantee of a minimum return
Whew!  It took me about 10 minutes to put together this spreadsheet comparing the possible rate of return of the Banco Popular Structured CD versus the DJIA (less dividends).  I made the following heroic assumption on behalf of the Banco Structured CD:
DJIA goes up exactly 8% per year, PERFECTLY LINEAR (no variability) from month-to-month.
Structured_CD_Comp
Even in this case, the Structured CD returns almost $100 less on an intial $1,000 investment.  The straight index has an IRR of 8.3%, while the Structured CD linked to the index can only return 6.96% under the best of conditions.  It gets worse if the index goes down 20% for the first 2 years, then returns 40% overt the next 3 years.

 

6 – The CD Issuer could go the way of Lehman Brothers (and leave you with only your FDIC Guarantee).

 

7 – The issuer could change its mind and ‘Call’ the Structured CD.  In some contracts, language exists that lets the bank/issuer re-neg on the deal and ‘Call’ the CD part way through the contract.  You’ll likely get your money back plus a few years’ accrued interest, but not what the possible upside of the entire contract was if you held it to maturity.
8 – Wall Street Investment Bank ‘Ambulance Chasers’ love to go after them. You know there are some rotten products when there are ‘Mesothelioma-like’ webpages on the internet advertising the services of lawyers who will represent you in a class-action lawsuit against your Structured CD issuer.

 

9 – Phantom Income – Many Structured Products only pay out their return (interest) at the end of the contract.  However, the issuing bank could still slap you with an annual 1099-INT for ‘Accrued Income’ – Interest you earned, but that has not yet been paid.  This means you get the worst of both worlds- You get to pay taxes on interest that’s not in your pocket yet, which sucks.You’re probably best off holding a Structured CD inside a retirement account anyway, as the income they generate is income, not capital gains.

 

10 – Still not spooked?  The FDIC issued a warning in the spring of 2012 on Structured CDs.Bottom Line:  There’s a lot of homework to do in the purchase of a Structured CD.  You’d better understand what you’re getting yourself into, and how long your money is locked up.  If you can’t understand the prospectus on the first read, then it probably means the Structured Product was crafted by a Battalion of PolyMaths, Attorneys, and Actuaries – So it’s not likely you’re going to outsmart them!

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2 thoughts on “10 Reasons Structured CDs Suck

  1. 1) not true you can buy them in $1K increments
    2)not true. They are no load. Yes brokers make commissions (1-3%) but it is baked into the payout formula
    3)It’s a CD thus not a security like a mutual fund or ETF. It has FDIC insurance. This trumps anything the SEC has.
    4)BRIC is arcane?
    5)ok I’ll give you this one. Just buy point to point uncapped
    6)If we have another environment where a bank goes under and you are left relying on FDIC insurance that means the market is in a free fall and you wouldn’t have made money anyway. Banks don’t go under when the market is going up.
    7)not true unless it’s specified and it’s only a specific type of CD
    8) not true. you’re mistaking them for structured notes (no fdic insurance)
    9) that’s why they’re IRA products
    10) you could say the same thing about any investment product or prospectus

    Reply
    • Jim –

      Thanks for reading, and thanks for the commentary.

      I’m not 100% against Structured CDs. At the time of the original post (as well as today), I happen to own an S&P500 structured CD inside an IRA account. Just thought I’d summarize some of the disadvantages here.

      In case you have not seen the matching post in the series, here are reasons I believe Structured CDs Rule: http://wp.me/p2Nyqo-oP

      Reply

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