There’s a big reason CDs have been so popular this year. It’s pretty easy to lock in a CD at a rate of 5%, which is a pretty good return on a risk-free investment. All you need to do to not lose money with a CD is stick to an FDIC-insured bank and make sure to limit your deposit to $250,000. (And leave your money in the CD for the entire term.)
Investing in stocks, on the other hand, is a much riskier prospect. You could start out with a portfolio worth $5,000 only to see its value fall to $4,500 within the week. That can be a tough thing to wrap your head around.
But while stocks carry more risk than stocks, banking on CDs to save for your retirement is a pretty risky move in its own right. In fact, relying on CDs to build your retirement nest egg could cost you hundreds of thousands of dollars in the long run.
The difference is staggering
It’s easy to see why you might look to CDs to save for retirement. CD rates are attractive right now. And you might sleep better at night knowing your money is safe. But relying on CDs to build a retirement nest egg could leave you sorely short on funds for your senior years — especially since today’s higher rates aren’t the norm.
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Still, let’s say you have $25,000 you have earmarked for retirement. Let’s also imagine you’re able to snag a 5% APY on a CD for the next 30 years, which is pretty unlikely, but we’ll go with it for this hypothetical. In that case, you’re looking at turning that $25,000 into about $108,000.
On the other hand, let’s say you invest that $25,000 in an S&P 500 index fund. There’s a decent chance you’ll snag an average annual 10% return on your money, since that’s consistent with the stock market’s average over the past 50 years. In that case, you’re looking at turning your $25,000 into about $436,000.
When we calculate the difference between $436,000 and $108,000, we get $328,000. To give that number some context, the average baby boomer today has $120,300 in retirement savings, according to Northwestern Mutual.
If you were to stick with CDs in this example, you’d have less than that $120,300 (though interestingly, you’d have pretty much exactly what the average Gen Xer has socked away for retirement today). If you were to go with stocks instead, you’d have close to three-times the savings of the typical baby boomer.
Know when to fall back on CDs
When you’re getting close to retirement, it’s a good idea to pull some of your money out of the stock market and keep it in cash. The logic is that you may need to spend your nest egg within a few years. So you want some of it in cash in case the stock market crashes and it’s a bad time to liquidate investments for income.
Because of this, if you’re within a year or two of retirement, now’s actually a great time to open a CD. But if you’re in your 20s, 30s, 40s, or 50s, and you know retirement is at least seven years away, then you should still be investing heavily in stocks, since you have time to ride out market downturns.
There are plenty of good reasons to open a high-rate CD today, such as if you’re saving for a near-term goal or need a place to park some cash for a shorter period of time while you figure out what to do with it. But for the most part, CDs are not an ideal tool for building retirement wealth. The sooner you realize that, the better equipped you’ll be to avoid an income shortfall.
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