How Our T. Rowe Price Tax-Efficient Saver Portfolios Have Performed
A three-year checkup on performance, tax efficiency, and holdings.
Leave the index funds and ETFs to Vanguard, Fidelity, Schwab, and BlackRock. T. Rowe Price has long been known for its actively managed offerings.
So why on earth would we recommend portfolios featuring index funds that are notably more expensive than many other index funds and ETFs?
In a word, taxes. Whereas my T. Rowe Price Retirement Saver Portfolio for tax-deferred accounts included topnotch actively managed offerings like T. Rowe Price Dividend Growth (PRDGX), T. Rowe Price New America Growth (PRWAX), and T. Rowe Price Small-Cap Value (PRSVX), those funds aren't managed with any consideration for taxes. That means that capital gains taxes, in particular, will tend to weigh on their returns. Equity index funds, because they trade less and realize fewer taxable capital gains, tend to be more tax-efficient than active. Therefore, it's only reasonable to include them as core holdings for equity-heavy portfolios.
True, some of T. Rowe's actively managed funds have managed to beat index funds on an aftertax basis, mainly because their pretax returns have been so strong. The fact that such funds generally grew over the past 15 years, and therefore could spread their capital gains over a larger base of shareholders, also helped on the tax-efficiency front. But whether these actively managed funds will be able to produce strong aftertax gains in the future is an open question. Even if their managers continue to deliver the goods on a pretax basis, capital gains distributions could erode their advantage after taxes are factored in. That consideration is particularly important right now, as many mutual funds have sizable embedded capital gains thanks to the multiyear rally in equities.
As I did with my core T. Rowe Price Retirement Saver Portfolios, which are geared toward tax-sheltered holdings, I'll use the three-year anniversary of the portfolios to check up on their performance and assess whether any changes are in order.
A Hands-Off Approach
Before getting into the checkup, it's worthwhile to review the basic strategy behind the portfolios.
As with all of the model portfolios, I used Morningstar's Lifetime Allocation Indexes to guide the asset-class exposures for these tax-efficient T. Rowe portfolios. To help populate the portfolios with specific funds, I leaned on Morningstar's medalist ratings. Because there weren't tax-efficient T. Rowe medalists in every category I wanted for these portfolios, I also consulted with Morningstar's manager research team: Katie Reichart, Sarah Bush, and Dan Sotiroff. Note that the portfolio doesn't include exposure to each and every asset class included in the tax-deferred portfolios. I excluded commodities and Treasury Inflation-Protected Securities exposure because of their heavy tax costs, for example. Meanwhile, T. Rowe Price International Equity Index (PIEQX) excludes developing markets.
Investors will, of course, want to bear their own situations and anticipated drawdown needs in mind before adopting any of these portfolios' allocations as their own. For example, if an individual is closing in on retirement but will be able to rely on a pension to meet their income needs in retirement, the Conservative portfolio featured here may, in fact, be too bond-heavy for their needs. On the flip side, a younger investor who is earmarking part of a taxable portfolio for a remodeling project in five years shouldn't run with the Aggressive portfolio; its 90% equity weighting could drop at an inopportune time, reducing the amount that's available to fund near-term goals.
Aggressive Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 40 years
3-Year Annualized Return: 11.47%
3-Year Tax Cost Ratio (Portfolio): 0.74
The Aggressive T. Rowe Price Tax-Efficient Saver Portfolio returned more than 11% on an annualized basis over the past three years, a robust gain that owes in no small part to its 90% equity weighting. The portfolio has also benefited from keeping things simple on the equity side. While T. Rowe Price Total Equity Market Index isn't the cheapest total market tracker in town, its 15% annualized return over the past three years trumps most active equity funds. Thanks to that fund's strong showing, in fact, the tax-efficient T. Rowe Price Aggressive portfolio returned only slightly less than the Aggressive T. Rowe Price portfolio that is managed without regard for tax efficiency.
Because this portfolio has higher weightings in equities, which have higher tax cost ratios than the firm's muni bond funds, its tax-cost ratio is the highest of the three tax-efficient portfolios. Foreign companies tend to pay larger dividends than U.S., so that too has boosted the tax costs of owning this portfolio, which has a larger stake in such names.
Moderate Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 20-Plus Years
55%: T. Rowe Price Total Equity Market Index
25%: T. Rowe Price International Equity Index
20%: T. Rowe Price Summit Municipal Income
3-Year Annualized Return: 10.54%
3-Year Tax-Cost Ratio: 0.66%
The Moderate T. Rowe Price Tax-Efficient Saver Portfolio returned nearly 11% on an annualized basis over the past three years. Although its equity weighting is lower than that of the Aggressive portfolio, not holding as much in foreign stocks, which underperformed U.S. over the period, was a help.
Conservative Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 10 Years or Fewer
50%: T. Rowe Price Total Equity Market Index
15%: T. Rowe Price International Equity Index
20%: T. Rowe Price Summit Municipal Income
15%: T. Rowe Price Tax-Free Short-Intermediate (PRFSX)
3-Year Annualized Return: 9.18%
3-Year Tax-Cost Ratio: 0.53%
With 35% of its assets in bonds, this portfolio's returns were naturally below its more equity-heavy counterparts amid the strong equity market over the past three years. This portfolio's tax efficiency was excellent, though, thanks to its heavy tilt toward the tax-efficient muni funds. T. Rowe's muni funds haven't delivered standout returns over the past three years, but that's to be expected given that the firm's funds typically run to the mild side of their categories.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.