Wednesday, November 3, 2010

PenFed 7-Year CD

I recently initiated the process to do a partial rollover (transfer) from a money market in my Fidelity IRA account to a 7-year IRA CD at Pentagon Federal Credit Union (PenFed). The CD rate is 3.5% through the end of November 2010, and the withdrawal penalty is one year of interest (if you withdraw funds from the CD before one year, you sacrifice all interest, but get all of your principal back). Following is a summary of my experience with PenFed so far, and the reasoning that led me to go for the PenFed CD.

What is PenFed?

PenFed is a credit union intended primarily for military and ex-military families, but it’s easy for anyone to join. Anyone who does not meet the eligibility criteria (which include things like donating blood to the Red Cross) can join by paying a small one-time fee of to join the National Military Family Association ($20) or Voices for America’s Troops ($15). Deposits are insured by NCUA (which is like FDIC for credit unions).

Why PenFed?

Although you can buy CDs at Fidelity, Vanguard, and other brokers, you usually can get much higher rates when you buy directly from certain banks and credit unions, such as PenFed. Also, when you buy a CD through a broker, the only way to get your money out early is to sell the CD, and since the value of a brokered CD responds to interest rate changes like a bond, the value of a brokered CD could decline significantly if interest rates were to increase. By contrast, with a bank or credit union CD, you typically only give up some interest if you withdraw early. With a PenFed CD, you always get all of your principal back.

PenFed is popular with many investors who participate in the Bogleheads investment forum, which I usually visit daily. There’s an article on PenFed in the Bogleheads Wiki (which incidentally is a great resource for learning about investing). PenFed is known among Bogleheads for its consistently high rates.

In a recent post I noted that I really like the Ally Bank 5-year CD because of the low early withdrawal penalty of only 60 days of interest, but Ally doesn’t yet have an IRA CD product. Although Ally is supposedly coming out with IRA CD products before the end of the year, I decided to get some of my IRA money into the PenFed CD now in case interest rates drop more before Ally comes out with its IRA CDs.

It’s Easy to Do

It only took me a few minutes to complete the PenFed online application, and I was able to make my small initial deposit (and pay the $15 fee) with my credit card. No forms or checks to mail, although I’m supposed to receive some paperwork which I’ll need to sign and return.

Immediately after joining, I downloaded the form to do the IRA rollover. I called PenFed to see if I could do the rollover online, but was told I had to fill out the form. The rep told me that although there are a lot of pages, I only needed to fill out and return 2 pages, and that I could scan and email the application to them, which is what I did (you also can mail or fax the form). Now I’m waiting to see if the rest of the process goes as smoothly.

PenFed CD vs. Bond Fund

With money market rates close to 0%, short-term bond rates between 0.3% (treasuries) and 1.75% (investment grade), and intermediate-term bond rates between 1.3% (treasuries) and 3.1% (investment grade), the PenFed 7-year CD rate of 3.5% is very good. The other big factor is that the downside risk of the CD is limited to losing up to one year of interest, whereas the downside risk in a bond fund is much higher. If interest rates were to rise only 1%, the value of a typical short-term bond fund would decrease by about 2%, and the value of a typical intermediate-term bond fund would decrease by about 5%.

To illustrate, assume intermediate-term interest rates steadily increase by 1% over the next year. With an intermediate-term bond fund currently paying 3%, your fund value would decrease by about 5%, and you would receive about 3.5% in interest, for a net loss of about 1.5%. With the PenFed CD, you could pull your money out after 1 year, and although you wouldn’t receive any interest you would still have all of your principal; i.e., a net gain/loss of 0%. If interest rates were to increase by 2%, your net loss in the bond fund would be about 6% (10% decrease in value plus 4% interest), and again, your net loss in the CD would be 0%. The more interest rates rise, the worse it gets for a bond fund, but it doesn’t get any worse for the CD.

If rates hold steady, you come out ahead with the CD because the interest rate is higher than the bond fund rate.

Of course if rates decline, you come out ahead (at least for awhile) with the bond fund, since the value of the fund will go up. However, you’ll then be receiving an even lower interest rate from the bond fund, but you would continue to receive the higher rate from the CD. Also, there’s only so much more rates can go down, but they could go up a lot.

It’s Not All or Nothing

Note that what I’m doing is a partial IRA rollover. With a partial rollover, you transfer some of your IRA assets from one custodian (financial institution) to another. You can have IRAs at as many financial institutions as you want, although many people prefer the simplicity of having only one IRA custodian. I’m doing a partial rollover from Fidelity to PenFed. When the partial rollover is complete, I’ll have a new IRA at PenFed, and I’ll still have my IRA at Fidelity.

I have IRAs at Vanguard and Fidelity, and still have significant assets in bond and money market funds at both. I know that when rates rise the value of my bond funds will decrease, and I know that I’m earning next to nothing in my money market funds. By diversifying into CDs, at least part of my money is earning a much higher interest rate than my money market funds, and is subject to less risk than my bond funds. I’ll probably roll over more IRA funds into bank or credit union CDs in the near future.

PenFed CD vs. Ally Bank CD

PenFed currently pays 2.75% on a 5-year CD with a 6 month interest penalty for early withdrawal, compared to 2.49% for a 5-year Ally CD with a 60 day interest penalty. For taxable accounts, I’ll take the slightly lower rate at Ally in return for the lower cost to break the CD and reinvest in a higher-yielding CD if interest rates increase significantly in the next few years.

If you believe interest rates will remain low for a long time, then getting the extra 1% in the PenFed 7-year 3.5% CD (compared to the Ally 5-year 2.49% CD) may be worth the risk of paying the higher early withdrawal penalty (i.e., if you’re wrong and interest rates increase a lot).

Of course if you’re working with an IRA, Ally Bank currently doesn’t have a CD product for you, which is why I went for the PenFed 7-year CD. I’m anxiously awaiting the IRA CD products from Ally Bank.

Another PenFed Benefit for Retirees

Another huge benefit of a PenFed CD for retirees is that PenFed does not charge an early withdrawal penalty for early withdrawals from the CD if you’re 59 1/2 or older; you just need to leave at least $1,000 in the CD to keep it open. If you’re taking withdrawals from your IRAs anyway, you then have the option to take a penalty-free early withdrawal from the PenFed IRA CD if interest rates rise, then invest other IRA money in a new higher-rate CD.

The PenFed customer rep clarified for me that you cannot take a penalty-free early withdrawal from the CD and deposit it in your IRA savings account at PenFed; i.e., you have to take a distribution from your IRA (and pay any taxes that may be due).

Stay Within FDIC/NCUA Insurance Limits

If you have significant funds in the fixed-income portion of your portfolio, be sure that you don’t exceed the FDIC/NCUA limit of $250,000 per depositor, per insured depository institution for each account ownership category. Remember to consider the interest that will be earned on the CD; i.e., you want to stay within the insurance limits after the CD has increased in value due to earned interest.


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