People who use certificates of deposit (CDs) to store their money safely tend to do so to avoid the risk associated with market-based assets, such as stock and bonds. However, for long-term investors, CDs may present a different type of risk that can be just as harmful as market risk – the risk of inflation. If the return on an investment does not at least keep up with the rate of inflation, it will result in the loss of purchasing power over the long term.
Currently, the rates on CDs barely exceed the current Consumer Price Index (CPI) rate. CD rates tend to track the CPI, which should alleviate concerns over inflation risk. However, a closer examination of how inflation is measured may be a cause for concern if you're worried about your actual purchasing power in the future.
CDs vs. CPI
As of October 2018, the average one-year CD rate was 0.17%. The average five-year jumbo CD rate was 1.44%. Although the margin is slim, CD rates are exceeding the rate of inflation as measured by the CPI. However, the CPI may not be an accurate measure of inflation as it pertains to being able to maintain your purchasing power. You need to consider other measures of inflation.
CDs vs. Core CPI
The primary difference between the CPI and the Core CPI is the CPI doesn't include oil and food prices. With oil and food prices factored in, the Core CPI stood at 1.89%, more than 10 times higher than the CPI rate. The CPI is the number the government likes to report, but the Core CPI is the number most economists tend to follow. If you apply the Core CPI to the CD versus inflation equation, CDs are behind by a large margin.
CDs vs. Lifestyle Inflation
The inflation rate that should matter most to consumers and CD investors is what they actually feel in their wallets. Even if oil and food prices were included in the CPI, if you don't drive often, or you don't eat a lot of corn, you may not feel the same effects of inflation as your neighbor. Lifestyle inflation, which is driven largely by your consumption habits, has the most direct impact on purchasing power. Since most people consume gas and food, it would be very difficult to keep your lifestyle inflation rate much below the Core CPI rate. For many people, it can be much higher.
CDs and Taxes
By some measures, CDs may be able to keep up with inflation. However, your actual purchasing power is based on your income after taxes. The interest earned from CDs held outside of a qualified retirement plan is taxable as ordinary income, so the net return of CDs is reduced by your effective tax rate. If your effective tax rate is 25%, the net return of a CD yielding 1% is only 0.75%.
No matter which method you use to measure inflation, the after-tax return of traditional CDs is no match for the rate of inflation. If you're intent on investing in CDs due to a low tolerance for risk, consider some CD products that can potentially boost your returns without sacrificing safety.
For example, indexed CDs offer higher potential returns with the principal guarantees of a CD. Indexed CDs are linked to a market index, such as the S&P 500, which pays an interest rate that fluctuates with the market. The rate is usually capped on the upside; if the market index shows a loss, you'll still receive a minimum interest rate. These are more complicated vehicles than traditional CDs, but they can offer safety-conscious investors the best of both worlds.