(PUB) Investing 2016

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 >

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

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

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.)

After Taxes, Takes Decades for Annuity to Catch Up

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.

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Annuity pre-tax Taxable fund (85% tax efficient) Annuity after tax Taxable fund after tax

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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?

The Independent Adviser for Vanguard Investors • April 2016 • 15

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