(PUB) Investing 2016

choice if you are looking to create bal- ance between stock and bonds in your portfolio. In fact, holding your bond investments in a variable annuity can be an effective means of sheltering your income and allowing it to compound tax-deferred, while holding “growth” investments in a taxable account. Of course, the same caveats about higher expenses in annuities still apply. For years I have warned about “total” bond market index funds and their exposure to U.S. Treasury and agency bonds—this fund is no excep- tion. U.S. Treasury and agency bonds, which are the highest-quality bonds, are also the most sensitive to changes in interest rates, and make up more than 40% of this portfolio. The result is that investors are increasingly taking on interest-rate risk while being paid less income. I suspect many investors here are unaware of the perils. High-Yield Bond Annuity Buy. A clone of High-Yield Corporate , this portfolio’s ups and downs have more closely tracked the stock market than the bond market over time. Companies that issue high-yield bonds tend to be more dependent on the economic cycle. When the economy is weak, investors question the prospects of these companies and their ability to make good on their debts. But when the economy is expanding, this portfolio should benefit. Investors saw this in spades last year and early in 2016, as the falling price of oil and struggling energy sector weighed on high-yield bonds. For all the risk that people associ- ate with junk bonds, keep in mind that High-Yield Bond Annuity is less risky than most. Most junk funds would never buy the stuff in High-Yield Bond Annuity—it’s too high-quality for them. That higher level of quality keeps returns muted when the economy is steaming along, but will protect inves- tors when the economy or the junk market turns south. For a deeper dive on high-yield bonds, see the story High Yield: Opportunity or Trap? on the front page of last month’s newsletter. In >

other financial penalties on withdraw- al, carefully balance out these factors before locking up your money for an extended period.” Annuities are far from the invest- ing remedy they are often made out to be. All of that being said, there’s little question that Vanguard’s annuity pro- gram is one of the best in the industry. As you’d expect with Vanguard, their fees are among the lowest in the busi- ness. And though limited in scope, the program does give you access to some top-notch managers. While many of Vanguard’s annuity funds are clones or near-clones of funds I talk about all the time in this letter, here’s a brief review to remind you of the various options. Money Market Annuity Unrated. This fund is a clone of Prime Money Market . Once the most popular annuity option, Money Market Annuity has lost its cachet, though I’m left scratching my head how there is still over $1 billion invested here. Yields on money markets of all stripes have been pinned near zero for years. As the chart above shows, high expenses have swamped meager yields, generating negative returns. Ask yourself when (if ever) you last saw a money market chart that went downhill was! The fund’s last positive calendar year was 2009. With the Fed on pace to gradually increase interest rates, there is light at the end of the tunnel for holders of this annuity. But my longstanding cau- tion that parking money in any cash account is not a good investment for the future—particularly when your vehicle is an annuity—still stands. Inflation and the annuity’s higher expenses work to erode your returns. Then taxes take the final bite. A money market annuity can be effective when you are transition- ing cash into or out of an annuity. It’s a money management tool, not an invest- ment. I prefer the next fund for short- term cash reserves. Short-Term Investment-Grade Annuity Buy. This is a clone of Short- Term Investment-Grade . This annu-

Money Market Annuity’s Tumble

$1.895 $1.897 $1.899 $1.901 $1.903 $1.905 $1.907 $1.909 $1.911 $1.913 $1.915 $1.917

Value starts falling 12/1/09

▼

▼ Value tops out 8/14/09

▼ 3-year return goes negative 1/24/12

▼ Value stops falling 7/19/10, then starts again 9/15/10

5-year return goes negative 11/29/13

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Value bottoms 12/14/15

▼

3/09

3/10

3/11

3/12

3/13

3/14

3/15

3/16

ity option can serve as a place to put money you expect to withdraw in a couple of years, or as a buffer for mar- ket volatility in a diversified portfolio of annuities. It will definitely serve you better than a money market. Yet, while it’s a superior cash alternative to Money Market Annuity, this is still not a preferable pick if you are looking to grow your wealth over the 10-plus years needed to make annuity investing even begin to be worthwhile. Total Bond Market Annuity Hold. A clone of Total BondMarket Index . The portfolio consists of a mix of U.S. Treasury bonds, high-grade corporate bonds and mortgage bonds. With an intermediate-term maturity, this bond fund has historically provided investors with about 70% to 80% of a long-term bond fund’s returns, with only about half the risk. This is a good

Matching and Mixing Model Portfolio Recommendation

Variable Annuity Substitute Capital Growth Diversified Value

Capital Opportunity Dividend Growth

Health Care

Cap. Growth (60%) + Equ. Index (40%)

High-Yield Corporate High-Yield Bond Intermed.-Term Inv.-Grade Total Bond International Growth International MidCap Index MidCap PRIMECAP Core Capital Growth Diversified Value Short-Term Inv.-Grade Short-Term Inv.-Grade Note: There are many imperfect matches between my favorite Vanguard funds and the offerings in the annuity plan. That said, this is a list of the options that are closest. S&P MidCap 400 ETF MidCap S&P MidCap 400 Gro. ETF MidCap Selected Value

The Independent Adviser for Vanguard Investors • April 2016 • 13

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