(PUB) Investing 2016

FUNDS FOCUS Variable Annuities Don’t Match the Hype

top, annuities have a “death benefit” to protect your loved ones when you pass. That all sounds great on paper, and if variable annuities lived up to every promotional claim, this wouldn’t even be a conversation. But reality has a way of tarnishing this image. Let’s start with expenses. Broadly speaking, annuity expenses are outland- ish, with sales agents regularly earning 5% or more in fees. (This is one reason some say that annuities are sold, not bought.) Plus, their ongoing operating expenses tend to be high—really high. True to form, though, Vanguard’s annui- ties are among the cheapest around. But compared to a Vanguard mutual fund, they are still astronomically priced. One example: While good old 500 Index currently charges 0.16% in oper- ating expenses, the identical Equity Index Annuity charges 0.44% at a minimum. A few dozen basis points isn’t usually worth getting too worked up about, but that higher fee is going to chip away at returns month after month, and, well, it adds up over time. Over the 10 years ending in March, the annuity has lagged 500 index by 30 basis points per year, which translates into a total return of 89.3% for the annuity versus 94.6% for the index fund. In addition to those high fees, you could be hit with a penalty for early withdrawals should you need your money sooner than expected. While Vanguard’s annuities do not have “withdrawal charges,” other annuities do. And with all annuities, including Vanguard’s, withdrawals made before age 59.5 may be subject to an addi- tional 10% federal penalty tax. No such penalty exists with a regular mutual fund, except for short-term redemption fees, which typically only last from 30 to 90 days from purchase. Even the issue of growing your money in a tax-deferred manner isn’t cut-and-dried when it comes to annui- ties. I love tax-deferred investing. Every dollar you invest and every dol-

ANNUITIES SOUND LIKE a silver bullet for retirement: Tax-deferred growth and guaranteed income for life. Everyone should have one, right? Well, at this point in life, we’ve all learned that if something sounds too good to be true, it probably is. So let’s take a look at what annuities are and are not—and why Dan and I remain skeptics. Annuities are insurance contracts, and they come in many different forms. Income annuities require that you hand over a lump sum of cash to an insurance company, and then that company pays you regular income for the term of the contract—usually life. Those payments can start immediately or years down the road. They can be fixed or tied to inflation. As with so many things, the devil is in the details. When it comes to annuities, well, it all depends on your contract. A simple story told by an annuity sales rep can quickly become dizzyingly complicated. Vanguard no longer offers its own income annuity, but does provide a platform to compare quotes from various insurance compa- nies. What Vanguard continues to offer, though, is another flavor of annuity— deferred variable annuities. So let’s dig in there. Here’s how deferred variable annui- ties are supposed to work. First off, most investors will begin building a tax- deferred portfolio by maxing out their IRAs and 401(k)s or other retirement or tax-deferred investment options. Of course, there are limits to how much you can put into these retirement port- folios. But you aren’t limited in your purchase of a variable annuity—you can put in as much as you like. In some situations, you can also add to the annu- ity over time. You choose how your money is invested, and your money grows without the drag of taxes. Then, in retirement, your annuity provides a steady, and in some cases, guaranteed, stream of income regardless of what the market does. And as a cherry on

lar earned in additional gains keeps on compounding until you take your money out. I fund my 401(k) retire- ment account and my IRA to the max, and always recommend that you do likewise. (And just last month, Dan recommended you kick-start your kid’s retirement with a tax-deferred Roth IRA. So we’re both big believers in tax- deferred investing.) So what’s the catch? First, it can take a long time for the benefits of tax defer- ral to compensate annuity buyers for the higher expenses annuities charge. Even Vanguard concedes that “it may take ten years or more for the benefit of tax deferral to offset the costs associ- ated with a variable annuity.” Another wrinkle in the tax-defer- ral story is how your withdrawals are taxed. If you funded your annuity with pre-tax dollars, then every dollar you take out—whether it is from your prin- cipal or profit earned through divi- dends or capital gains—is considered “income” to the tax man. If you funded your annuity with after-tax dollars, only the profits you withdraw are taxed—but they are still taxed as income. It’s all a matter of tax efficiency. Take a look at the accompanying piece on page 15 for a more in-depth review. While your money grows more quickly in a tax-deferred annuity, even under favorable assumptions, by the time you consider the higher expenses and the tax consequences of paying income versus capital gains taxes, you need to hold an annuity for decades to make it worthwhile. Now, remember that death benefit I mentioned? The language in most death benefit provisions says that your benefi- ciary is entitled to your annuity’s assets on your death. Simple. But as with all things related to annuities, the matter is a bit more complicated. You only die once, but Vanguard offers investors the choice of two death benefits.

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The Independent Adviser for Vanguard Investors • April 2016 • 7

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