(PUB) Investing 2016

The Independent Adviser for Vanguard Investors

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April 2016

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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.

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

$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