Low-risk Doesn't Mean No-risk
Certificates of deposit, or CDs, offer a guaranteed interest rate for a set time period, commonly six months, one year or five years. CDs are FDIC insured, and they typically pay higher interest rates than savings accounts in return for locking your money in for the contracted amount of time -- the longer the term, the better the interest rate. While some banks go as far as to promote "risk-free CD" products, even these so-called "safe" options involve risks associated with inflation and reduced liquidity that you will want to consider before you invest.
Although they often pay more than standard savings accounts, CDs offer a lower average rate of return than more aggressive investments. If you find yourself locked into a multi-year CD as inflation and interest rates rise, it may actually cost you to keep your money there. The shorter the term, the lower the inflation risk, but the lower the interest rate, too. And if you find yourself needing to cash in your CD before the contracted term, you will pay a penalty equal to some or all of the interest generated, and possibly additional withdrawal fees, depending on your specific contract.
Since savings accounts are insured by the FDIC (up to $250,000), the risks associated with this investment option have to do with what your money isn't doing, as well as with the cost of maintaining the account itself. Savings interest rates are typically low, and bank charges and minimum balance fees can quickly erode any earnings. In addition, the earnings you manage to accumulate will be taxed as interest income. And as with any low-return investment, you run the risk that your returns won't keep up with the rate of inflation.
The term money market applies to two types of low-risk investment that are actually quite different from one another [source: Bernard]. A money market fund is a mutual fund that invests in low-risk (but not risk-free) securities. A money market deposit account, similar to a savings account, is an FDIC insured interest-bearing bank account. As with savings accounts, money market accounts carry the risk of losing value to inflation and account management fees.
With fixed annuities, an insurance company or other financial institution offers investors a certain rate of return for a specified time frame on whatever money they invest. While the returns are typically higher than a savings account or CD, the up-front investment can be significant and the funds invested are not insured by the FDIC, so if the company issuing the annuity fails, the investor is out of luck.
The options we've covered so far all carry some level of risk, however small it may be. But one government-backed investment option is widely considered the closest thing there is to risk-free. What is it? Read on to find out.