The Independent Adviser for Vanguard Investors
•
April 2016
•
15
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Barrow’s two successors closely. Now
that Equity Income Annuity has made
up lost ground—outpacing Diversified
Value Annuity over the past five years
by 2.5% a year—the two funds have
essentially matched each other since
Diversified Value Annuity’s inception.
Equity Index Annuity
Buy.
This fund, like its taxable coun-
terpart, 500 Index, attempts to mimic
the S&P 500 by owning all of the
stocks in the index. Of course, with its
higher expenses, this fund won’t track
the S&P as closely as 500 Index, as I
noted earlier. And that’s the rub. 500
Index is already managed in a very tax-
efficient manner—to the point where
Tax-Managed Growth & Income had
become redundant and was merged into
it. In the end, an investor may not need
to pay those higher annuity fees to find
tax-efficient investment solutions like
this annuity. If you must index your
annuity, this fund will work for you,
but I prefer Capital Growth Annuity for
long-term investors.
Growth Annuity
Hold.
This fund was the tax-deferred
clone of
U.S. Growth
up until February
2014. At that point, U.S. Growth
picked up two new sub-advisers when
it absorbed Growth Equity. Growth
Annuity kept the management struc-
ture it moved to in 2010 more or less
unchanged, divvying the funds’ assets
between three sub-advisers: William
Blair, Jackson Square Partners and
Wellington Management.
I’m glad to see the annuity didn’t
pick up more management teams,
and while the changes made in 2010
have helped performance, if you want
growth, I still recommend using Capital
Growth Annuity.
MidCap Index Annuity
Buy.
As a clone of
MidCap Index
,
this fund’s benchmark has changed
several times over the years. First, it
tracked the S&P MidCap 400, before
switching to the MSCI MidCap 450 in
2003. Then, in 2013, it completed its
most recent jump to the CRSP MidCap
index. I’ve long believed that mid-cap
stocks offer better bang for your buck
over time, and despite the index chang-
es, I continue to like this annuity option.
REIT Index Annuity
Hold.
Like
REIT Index
, this annu-
ity tracks the MSCI U.S. REIT (Real
Estate Investment Trust) index. Higher
yields make this fund a good alterna-
tive inside an annuity simply because
your income continues to grow, tax
deferred. Whether you want to have
much money invested in REITs is
another story. Once a “hybrid” security
that had characteristics of both stocks
and bonds, REITs seem now to vacil-
late between putting up gaudy returns
(up over 200% since the market bottom
in March 2009) and leading the race to
the bottom (losing over two-thirds in
the market crash). I’d be very careful
about putting too much money here.
Small Company Growth Annuity
Hold.
This annuity’s closest fund
relative is
Explorer
, which it has
Efficient Investing
AS LONGSTANDING FFSA MEMBERS know, Dan was one of the first investment advisers to
even consider a fund’s tax efficiency and to provide you with regular updates on each Vanguard
fund’s after-tax returns.
The chart below is the cold, hard mathematical illustration behind my claim that it takes a
long time horizon for annuities to make sense. Consider two investors: One invests in a regular
taxable mutual fund, and the other invests in an annuity clone of the fund. I’m going to load the
example in favor of the annuity. First, the annuity charges just 0.20% in additional expenses over
the fund, and upon withdrawal, our annuity investor is going to pay 38.8% income tax on all his
gains, but not on his original contribution. (I’m going to ignore the penalty for withdrawals before
the age of 59.5, too.)
I’ll compare that to a fund investor who’s
only keeping 85% of his gains each year. In
other words, the fund has just 85% tax effi-
ciency, which is actually quite low. The taxable
investor is then further taxed at a 20% capital
gains rate upon selling the position.
As the chart shows, the annuity, despite
higher fees, grows much faster before taxes
than the taxable account. (In this example, I’m
assuming an 8% annualized rate of return for
both the fund and the annuity.) This is what
we would expect, and why I advocate funding
your retirement accounts to the max. Tax-
deferred investing can be a powerful tool in
growing your retirement assets.
But once the annuity investor takes his money and runs (and yes, I’m assuming the annuity
investor cashes out completely and pays his taxes on his gains), his net value falls behind the
taxable fund investor’s. In fact, it takes more than 20 years for the annuity investor to come out
ahead (the point where the dark blue and grey lines cross).
Remember that I said I was loading the example in favor of the annuity investor. If that inves-
tor had funded his annuity with pre-tax dollars, his after-tax value would be even lower (he’d
have to pay taxes on his entire annuity’s value) and the comparison would look even worse next
to the regular, taxable fund account.
So let’s return to square one. Think about the reason you’d consider investing in an annuity in
the first place: You want to avoid taxes. Then think of the alternative. Instead of committing your
money to a small selection of funds for 20 years or more—with higher minimums and expenses,
locked up until retirement and liable for taxes at your income tax rate when you withdraw—why
not pick a few tax-efficient funds instead?
After Taxes, Takes Decades
for Annuity to Catch Up
1
3
5
7
9
11
13
15
17
19
21
23
25
27
29
31
33
35
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
$160,000
Years
Annuity pre-tax
Taxable fund (85% tax efficient)
Annuity after tax
Taxable fund after tax
>