(PUB) Investing 2016

transferring your assets to the insur- ance company in exchange for regular income payments. This is one way to set a floor on your income in retirement, but keep in mind that you and your beneficiaries lose access to the principal and gains (it now belongs to the insur- ance company, not you), and the guar- anteed income is only as good as the insurance company standing behind it. The final kicker, and possibly my biggest concern about Vanguard’s annuities, is that there are only a couple of great investment options available. To Vanguard’s credit, a few of the annuities do offer access to some of the highest-caliber managers in its stable— but not many. Annuities are complicated—there’s no getting around it. At this point, I’ve hopefully convinced you that annuities need further study and that, well, they are not all they’re cracked up to be. Though Vanguard barely promotes these products, assets in the annuity family hit $23.6 billion at the end of 2015—a new high-water mark. As the graph below shows, net new cash flows have ticked up in recent years, and assets have more than doubled since the end of 2008. However, this recovery in assets has been driven almost entirely by the recovery in the stock market, as net new cash inflows only account for 16% of the asset growth over the past seven years. After years of successfully attracting assets from investors who owned other companies’ annuities, most of that money has been transferred over to the firm’s lower-cost offerings, putting the annuity business at Vanguard in a form of stasis. Even Vanguard’s founder, Jack Bogle, under whose watch variable annuities were introduced in 1991, has less than flattering things to say about them. “Rates of return earned on vari- able annuities are certain to be sig- nificantly lower than the pretax returns earned through direct ownership of the underlying mutual funds,” he once wrote. “Since the higher costs of annui- ties offset their tax benefits for a decade or more [and] investing in a variable annuity program is less flexible than simply owning a mutual fund outright and may involve significant tax and

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Maximum Withdrawal Percentages Before and After Purchase GLWB

Vanguard’s variable annuities, by default, carry the Accumulated Value death benefit, which awards your ben- eficiaries the value of your annuity upon your death. If the markets went up while you were putting money in, your beneficiaries get the contributions you made plus the gains you earned. If the markets declined, however, they may end up getting less than you contributed to the annuity. So there is no guarantee that your beneficiaries will receive, at a minimum, all the money you put into your annuity. It’s no different than what would happen in a regular investment account. You put money in, and what- ever happens, happens. Vanguard says this benefit is “included at no additional cost,” but there is no way to avoid the 0.195% charge for this death benefit— it is baked into the expense ratios of Vanguard’s annuities. The second option, Return of Premium , is more expensive, at 0.395%, but offers protection on the contributions. Under this option, beneficiaries are enti- tled to either the annuity’s accumulated value or the sum of the contributions less any withdrawals and applicable taxes, whichever is greater. That sounds great, but if you invest in an annuity for a long time (and remember, I said that you need to be here for decades to offset the costs), hopefully your account value will far outpace your contributions. In that case, you are essentially paying up for nothing—the accumulated value should be higher than the value of your contri- butions alone. One final gripe with the death benefit: There’s no step-up in cost basis, so your heirs will owe taxes on the full amount. The final piece of the annuity story is guaranteed income. Vanguard also offers an optional Guaranteed Lifetime Withdrawal Benefit (GLWB) rider— which it now calls “Secure Income”— on three annuities: Balanced Annuity , Moderate Allocation Annuity and ConservativeAllocationAnnuity . The GLWB is meant to provide a specific amount of income, set at the time of the purchase of the rider and dependent on when you begin taking withdrawals,

Purchase GLWB rider on or after May 1, 2013

rider before May 1, 2013

Age at First Withdrawal

Single Life

Joint Life

Single Life

Joint Life

<59

0.0% 0.0% 0.0% 0.0% 4.5% 4.0% 4.0% 3.5% 5.0% 4.5% 5.0% 4.5% 5.5% 5.0% 5.0% 4.5% 6.5% 6.0% 6.0% 5.5%

59–64 65–69 70–79

80+

regardless of what the market does, for the lifetime of the annuity. This is not a free service, however, and nearly three years ago Vanguard upped the cost while simultaneously lowering the maximum annual with- drawal percentage. (Yet another exam- ple that proves costs do not only go down at Vanguard.) If you purchased the GLWB rider prior to May 1, 2013, you continue to pay the 0.95% rate, but if you’ve purchased the rider since then or plan to someday, the annual charge is 1.20%. And Vanguard has the flexibility to increase the cost to as much as 2.0% in the future. As you can see in the table above, Vanguard reduced the maximum annual withdrawal percentage, which determines the amount of income you receive, by 0.5% for purchases made after May 1, 2013. Of course, if you are looking for guaranteed income, you don’t have to purchase the GLWB rider. You could always “annuitize” your assets. This means you convert your variable annu- ity to an income annuity by irrevocably

Little NewCash Flows to Vanguard’s Annuities

$25,000

Total Assets Net New Cash

$20,000

$15,000

$10,000

$5000 Assets in millions

$0

$-5000

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

12 • Fund Family Shareholder Association

www.adviseronline.com