Tax-Sensitive Investment Management: Why Ben Franklin Was Wrong By Jim Cracraft, Managing Director, Strategic Advisers, Inc.

Transcription

1 STRATEGIC ADVISERS, INC. Tax-Sensitive Investment Management: Why Ben Franklin Was Wrong By Jim Cracraft, Managing Director, Strategic Advisers, Inc. In this world nothing can be said to be certain, except death and taxes. Benjamin Franklin, 1789 KEY TAKEAWAYS Investors can potentially lose a significant portion of their returns to taxes. 3 Compounding after-tax returns can be important for wealth creation; investors often incorrectly focus only on pre-tax returns. Managing for after-tax returns can require sophisticated modeling tools, detailed tax-lot accounting, and year-round attention. EXHIBIT 1: Top U.S. federal tax rates 100% 80% 60% 40% 20% 0% Top income tax rate Top capital gains tax rate 2016 This Product Perspective describes the tax-sensitive investment management 1 techniques that Fidelity s Strategic Advisers, Inc. (Strategic Advisers), applies to taxable accounts in its tax-sensitive managed account offering. 2 Although Ben Franklin s celebrated saying, In this world nothing can be said to be certain, except death and taxes, reminds us that paying taxes is an inescapable fact of life, there are opportunities to reduce or defer taxes by employing specific tax-sensitive investment management strategies. The goal behind tax-sensitive investment management is simply to keep more of what you earn. But too often investors focus only on pre-tax returns when selecting their investments. This may be shortsighted as the overall impact of taxes on performance is significant: Morningstar cites that on average, over the 88-year period ending in 2014, investors who did not manage investments in a tax-sensitive manner gave up between one and two percentage points of their annual returns to taxes. A hypothetical stock return of 10.1% that shrank to 8.1% after taxes would have left the investor with a 20% lower return rate according to Morningstar. 3 Although these findings vary based on changing market conditions, potential tax consequences are always looming. Simply put, taxes shouldn t be ignored. Given that certain federal tax rates increased in 2013 and Congress continues to debate changes to the tax code, many investors are looking to employ tax-sensitive investment management strategies. When tax rates rise, so, too, does the potential value of active tax-sensitive investment management strategies. Data represents the top federal marginal ordinary income tax rates and long-term capital gains tax rates, including the Medicare surcharge, as reported by U.S. Federal Individual Income Tax Rates History, , The Tax Foundation, September 9, 2011, and Top Federal Income Tax Rates on Regular Income and Capital Gains since 1916, Citizens for Tax Justice, May 2004.

2 Are You Making the Most of Tax-Sensitive Investment Management Techniques? Many investors believe they have the time and resources needed to consistently monitor a taxable portfolio for tax-savings opportunities. In reality, this is an incredibly time-consuming task and one that demands research, analysis, and attention to detail throughout the year not just at year s end. If you are not managing your portfolio using the techniques listed below, you may be paying more than you need to in taxes. Tax-Sensitive Investment Strategy Description Defer Realization of Short-Term Gains Taking advantage of the differences between short-term and long-term capital gains tax rates is a straightforward way to help reduce a portfolio s tax burden. Harvest Tax Losses Selling one or more tax lots of an investment at a loss may allow an investor to use the loss(es) to offset realized capital gains and, potentially, a small portion of ordinary income. Use Loss Carryovers to Reduce Future Taxes Following a year with large portfolio losses, an investor may be able to carry forward losses to offset capital gains in subsequent years. Manage Exposure to Distributions Understanding the potential tax consequences of selling a fund or staying invested in the fund is critical as cost basis and tax rates differ widely. Invest in Municipal Bond Funds or ETFs Including municipal bonds and other asset classes, as appropriate, in a portfolio may help an investor attain desirable after-tax results. 2 FIDELITY INVESTMENTS Portfolio Advisory Services

3 PERSPECTIVE Paying Attention to Taxes May Boost After-Tax s At Strategic Advisers, our investment managers seek to enhance after-tax returns while balancing an acceptable level of risk in a client s portfolio by using a variety of tax-sensitive investment management strategies. We attempt to measure the value of our tax-sensitive investment management by calculating its strategies tax alpha, 4 as defined in Exhibit 2. We believe that using these tax-sensitive investment management strategies is a key to long-term investment wealth creation and may help build better after-tax returns. While the results for any particular period may vary, and may in some instances be negative, the tax alpha generated for tax-sensitive composite portfolios has returned anywhere from 2% to 63% in value added to cumulative returns over the 15-year history for which Fidelity has measurement data (see Exhibit 2). EXHIBIT 2: Hypothetical Value of Tax-Sensitive Investment Management for Range of Strategies (12/31/ /31/2016) Investment Strategy After-Tax Excess 5 Pre-tax Excess 6 Average Annual Tax Alpha 7 Cumulative Added from Tax-Sensitive Investment Mgmt. 8 All Stock 0.96% 0.95% 1.91% 62.60% Aggressive Growth 0.14% 1.35% 1.49% 45.07% Growth 0.01% 1.12% 1.13% 31.04% Growth with Income 0.07% 1.01% 0.94% 22.26% Balanced 0.27% 1.03% 0.76% 17.44% Conservative 0.45% 0.75% 0.29% 1.82% See Appendix A for detailed performance information, and see endnotes 4, 5, 6, 7, and 9 for more details on the calculation of these values. Performance shown is for the period 12/31/2001 through 12/31/2016, which represents a period starting when Strategic Advisers began calculating after-tax returns. Performance reflects client accounts managed by Fidelity Personalized Portfolios. Fidelity Personalized Portfolios launched July 2010; performance prior to such date reflects only Fidelity Private Portfolio Service accounts. Past performance is no guarantee of future results. Investment return and principal value of investments will fluctuate over time. s for individual clients may differ significantly from the composite returns and/or may be negative. All returns are asset weighted and include reinvestment of any interest, dividends, and capital gains distributions, if applicable. Only Fidelity Personalized Portfolios strategies that are all stock or utilize national and state-specific municipal bond funds are included. Availability of state-specific funds depends on the client s state of residence. Certain investment strategies, such as All Stock, may not be appropriate or available for some investors. Please contact your Fidelity representative to discuss your situation and investment strategy. AFTER-TAX PORTFOLIO EXCESS RETURN % BENCHMARK PRE-TAX PORTFOLIO EXCESS RETURN % BENCHMARK TAX ALPHA After-Tax Excess : The amount by which the annualized after-tax investment return for the composite portfolio is either above or below the annualized after-tax benchmark return 5, 9 Pre-tax Excess : The amount by which the annualized pre-tax investment return for the composite portfolio is either above or below the annualized pre-tax benchmark return 6, 9 Tax Alpha: Represents the value added (or subtracted) by the manager s tax-sensitive investment management and is the difference between the after-tax excess return and the pre-tax excess return 7 Cumulative Added from Tax-Sensitive Investment Management: Represents the hypothetical cumulative value of the tax-sensitive investment management over the full time period 8 3

4 The cumulative value can really add up, as shown in Exhibit 3. We created a hypothetical example using an initial $1 million investment in our Growth Strategy composite (70% stocks/30% bonds and short-term investments), from 1/1/2002 through 12/31/2016, with no contributions or withdrawals. The results, in dollars, of the potential additional value from tax-sensitive investment management was $310,444.* 10 The tax-sensitive value is cumulative, assuming that the tax savings are reinvested monthly, something the hypothetical investor could not do if he or she had to accrue cash in anticipation of paying estimated capital gains taxes. Strategies Used by Strategic Advisers for Managing Investment Taxes Some tax-sensitive investment management strategies, described below in more detail, are used by individual investors such as purchasing tax-free municipal bond funds (see pages 8 and 9 for details). Others may be more difficult to execute without the help of an experienced investment professional. For example, ongoing tax-loss harvesting can require sophisticated modeling tools and tax-aware investing expertise. Understanding which strategies can most benefit a portfolio, and how to apply them simultaneously, is something our tax-aware investment managers focus on continuously. Our tax-sensitive investment management starts when you transition your account. Other firms may require you to sell all of your securities and transfer in cash, but we will build a personalized portfolio around your highly appreciated holdings. EXHIBIT 3: Hypothetical Cumulative Value of Tax-Sensitive Investment Management Growth Strategy* Our tax-sensitive investment management starts when $2.4 you transition your account. Other firms may require you to sell all of your securities and $2.2 $2.23M transfer in cash, but we will build a personalized portfolio $2.0 around your highly appreciated holdings. $1.92M $1.8 Portfolio Value ($M) $1.6 $1.4 $1.2 $1.0 $ For illustrative purposes only A potential increase of $310,444 from tax-sensitive investment management Hypothetical Account Value with Tax-Sensitive Investment Management Hypothetical Account Value without Tax-Sensitive Investment Management * Based on strategy composites. (See Appendix A for information on the composites.) These results and Exhibit 3 are hypothetical and do not represent actual value added to client accounts. s for individual clients will vary. Performance shown represents past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, and you may lose money. 4 FIDELITY INVESTMENTS Portfolio Advisory Services

5 PERSPECTIVE 1. Defer Realization of Short-Term Gains To encourage shareholders to be longterm investors, the U.S. tax code effectively penalizes investors for taking short-term investment profits. That s why, for individuals in the top federal tax bracket, capital gains from taxable investments held less than one year are usually taxed at 43.4%. But if an investor waits to take the gain after owning the investments for a year, the tax rate drops to 23.8%. Taking advantage of the differences between short-term and long-term capital gains tax rates is a straightforward way to reduce a portfolio s tax burden. (See Exhibit ) While the don t sell until long term strategy is simple in theory, it can pose a challenge in practice, especially for portfo- lios that hold multiple individual positions with many underlying tax lots (some short term, others long term, based on when they were purchased) with different levels of embedded gains or losses. Even if the holding period were the only criterion for selling an investment, orchestrating these moves in a diversified portfolio would require a great deal of time and attention to detail. Exhibit 4 shows the benefit of deferring a sale of a short-term investment; however, there is also a risk component to the equation. If an investment s research outlook is bleak or it adversely affects risk in the overall portfolio, does deferring a sale still make sense? Our tax-aware investment managers monitor the tax lots in consideration of capital gains deferral, but they also carefully consider the risk and return expectations for each security before trading. EXHIBIT 4: Long-term gains cost less in taxes. An investor keeps 43.4% Taxes paid $10,000 HYPOTHETICAL PRETAX GAIN $5,660 After-tax gain $4,340 Taxes $7,620 After-tax gain $2,380 Taxes An investor keeps 23.8% Taxes paid REDUCING CAPITAL GAINS TAXES Take a hypothetical investment with a pre-tax gain of $10,000. In this case, the potential tax savings* available as the result of waiting for a year are $1,960, assuming the investor is in the top marginal tax bracket. $10,000 (43.4% 23.8%) = $1,960 The amount of time until long-term status is reached is important. Consider a $100,000 investment made 300 days ago that is now worth $110,000 (a gain of 10%). If the security were sold today, the tax bill would be $10,000 x 43.4% = $4,340, with an after-tax return of 5.66%. However, assuming the value has held steady, by waiting an additional 66 days, the tax liability drops to $2,380, and the return increases to 7.62%. Short term vs. 1 YEAR Long term *The taxes saved by waiting until a short-term investment gain (<1 year) becomes a long-term gain (greater than one year) can be calculated as follows: (gain $) x (short-term rate long-term rate) = tax savings. For this example, we assume the investor is subject to the top capital gains rate and is paying 43.4% on short-term gains and 23.8% on long-term gains. Tax savings will depend on an individual s actual capital gains and tax rate and may be more or less than this example. This is a hypothetical example for illustrative purposes only, and is not intended to represent the performance of any investment. 5

6 2. Harvest Tax Losses Savvy investors know that the government not only shares in their profits, but also in their losses. When one or more tax lots of an investment are sold below their cost basis (e.g., at a loss), the IRS gives the investor the opportunity to use these losses to offset realized capital gains and, potentially, a small portion of ordinary income. This is a powerful tax-sensitive investment strategy, because realized losses have an immediate and known value to the investor. So why do so many investors fail to take advantage of this economic benefit? Similar to the techniques for capital gains deferral, the theory is easier than the practice. To effectively harvest losses on an ongoing basis, an investment manager must continuously analyze every tax lot and decide when the tax-loss benefit warrants trading, then sell the precise lots that maximize that benefit. At the same time, the integrity of the portfolio a client s risk exposure and diversification must be maintained. For the typical high-net-worth portfolio with many EXHIBIT 5: Tax-Loss Harvesting May Offer Significant Benefits During Volatile Markets $250M $200M $150M $100M $50M $0 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Tax Savings DJ Total Stock Market (Price Index) Turbulent markets can offer tax-loss harvesting opportunities. * The right axis and blue line represents the movements of the U.S. stock market as measured by the Dow Jones U.S. Total Stock Market (Price Index). Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 U.S. Stock Market Level* MANAGING FOR TAXES YEAR ROUND MAY OFFER SAVINGS OPPORTUNITIES Practicing tax-loss harvesting throughout the year and not just at year s end can offer an investor numerous opportunities to potentially reduce their tax hit. As you can see in the chart to the left, tax-loss harvesting can be especially effective during volatile markets such as the ones in January, February, July, and November of Strategic Advisers, Inc., seeks to add value to clients portfolios by utilizing tax-loss harvesting techniques on an ongoing basis. In fact, Exhibit 5 highlights the potential tax savings accrued from harvesting losses throughout 2016 for clients in our Fidelity Personalized Portfolios. Methodology: This chart represents the cumulative total tax lot losses harvested or potential tax savings in all accounts in good order in the Fidelity Personalized Portfolios Program for calendar year 2016 with account values of $50,000 and above with at least 10 holdings. Each tax lot loss within the population of accounts was evaluated. The specific tax rate applicable to the respective client account was applied to calculate the dollar loss of each tax lot, applying the client s ordinary income tax rate to short-term losses and applying the client s capital gain tax rate to long-term losses. All capital losses harvested in 2016 may not result in a tax benefit in the 2016 tax year. Any remaining unused capital losses may be carried forward and applied to offset income in future tax years indefinitely. Results will vary. In our analysis over the past four years, cumulative tax savings from tax-loss harvesting differed from year to year and was as small as half the amount shown in the chart. Source: Fidelity Tax Accounting System as of 12/31/ FIDELITY INVESTMENTS Portfolio Advisory Services

7 PERSPECTIVE positions, this requires significant time, computing power, and detailed tax-lot accounting. The vast majority of individual investors don t have the time, desire, or tools necessary to maintain continual tax-loss harvesting. Tax-loss harvesting is often thought of at year-end, but academic research supports a continual, year-round approach. A study by Robert Arnott, Andrew Berkin, and Jia Ye 12 supports the notion that frequent tax-loss harvesting actually helps create more tax-loss harvesting opportunities. This is because new investments purchased from tax-loss harvesting proceeds are more likely to lose value in the short term and become tax-loss candidates themselves (relative to assets at a loss that aren t sold but maintained longer term). A tax-loss harvesting simulation in the same study resulted in almost 14% cumulative alpha over 25 years, after taxes, assuming 8% stock returns. 13 Our investment managers continuously look for tax-loss harvesting opportunities, with the goal of turning market volatility to their clients advantage while seeking to avoid wash sales. (See Watch Out For Wash Sales below.) Of course, fees associated with selling securities must also be factored into any tax-loss harvesting analysis. WATCH OUT FOR WASH SALES Effective tax-loss harvesting requires close tracking of potential wash sale rule triggers, whereby the purchase of a substantially identical investment 30 days before or after a sale at a loss will defer the benefit of that loss until the new shares are sold. Unfortunately, many individual investors and advisors may not be paying close attention: A survey by the CFA Institute* showed that half of surveyed advisors were not considering wash sales at all and only 22% had automated systems to help avoid them. When it comes to wash sales, Fidelity s investment managers leverage our technology and investment platforms to minimize the triggering of wash sales in the accounts they manage. * Tax-Aware Investment Management Practice, by Stephen M. Horan and David Adler, a 2009 study funded by the Research Foundation of CFA Institute. MANAGING TAX LOTS Many investors do not have the time, sophisticated tools, or the desire to effectively manage a portfolio. For example, effective use of cash from dividends, coupons, distributions, and contributions introduces additional tax lots, which can be an impactful way to not only build long-term wealth, but also improve after-tax returns. Typically, clients often end up with dozens of tax lots per position some at gains, others at losses, some short term, others long term. Keeping track of the cost basis, purchase date, and short/long status can be time consuming and complicated. While it may seem unnecessary to keep tabs on tax lots, doing so is a must for successful tax-sensitive investment management. Our investment managers closely monitor tax lots, and manually reinvest portfolio earnings rather than passively enabling dividend reinvestments. This way, they maintain full control over the next investment purchased and tax lot created. They also trade specific tax lots. Often clients will have accumulated a position by purchasing shares at different points in time. A tax lot is created each time you buy shares and thus will have a unique holding period and cost basis. Selecting the most advantageous lot to sell can be an effective way to help reduce your tax liability. 7

8 3. Use Loss Carryovers to Reduce Future Taxes Investment losses are not only valuable for offsetting gains in the tax year when they are realized, but also may be netted against future realized gains through loss carryovers. 14 A relatively simple component of a taxpayer s annual tax return filings, the loss carryover can have considerable power to reduce future tax liabilities, especially during periods of extreme market volatility. Take, for example, the 2008 market crash, in which most asset classes experienced significant declines in value. Although the persistent harvesting of tax losses by our investment managers may have seemed needless at the time, the strategy s value was demonstrated during the 2009 market recovery. As most asset classes rebounded sharply, the need to manage risk (by rebalancing) often resulted in taxable gains. Fortunately, carryover losses from 2008 helped to offset these gains for many clients and, in some cases, gains were realized in multiple years after The chart below shows a hypothetical example of this. As you can see, following a year with large portfolio EXHIBIT 6: Hypothetical example of how carryforward tax losses offset future gains. $10,000 0 A net loss becomes carryforward potential $6,000 $4,000 $4,000 $2,000 $3,000 $1,000 $4,500 total capital gain $1,500 $3,000 Taxable gain: $1, capital gain: $11,500 Capital Gain Taxable Gain $4,000 $0 $2,000 $0 $1,000 $0 $4,500 $1,500 Net Loss Tax Loss Carryforward $10,000 Net loss Capital Gain S&P 500 Index 1-year returns 37% 27% 15% 2% 16% Tax savings will depend on an individual s actual capital gains, loss carryforwards, and tax rate and may be more or less than this example. This is a hypothetical example for illustrative purposes only, and is not intended to represent the performance of any investment. The S&P 500 Index is an unmanaged market capitalization weighted index of 500 common stocks chosen for size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500 Data, Performance Workspace, FMRCo, December 31, FIDELITY INVESTMENTS Portfolio Advisory Services

9 PERSPECTIVE losses, an investor is able to carry forward that loss to offset capital gains in subsequent years. In this example, the investor used a $10,000 net loss in 2008 by utilizing the carryforward tax-loss strategy and avoided paying capital gains for the next four years. It wasn t until 2012 that gains resulted in a tax liability. This is important because compounding is key to wealth generation, so it s typically a good strategy to defer paying taxes as long as possible. 4. Manage Exposure to Distributions Each year, mutual funds must distribute most of the fund s net income to shareholders, which is usually taxable to those shareholders if held in a taxable account. So, another tax-sensitive investment management strategy involves monitoring capital gains distributions from mutual funds and incorporating this information into the investment process. Selling a fund to avoid the tax liability of a distribution is one option. However, even when faced with a pending distribution, this may not be the best course of action. Depending on a fund s cost basis and performance expectations, it may well be worth continuing to hold especially if the fund is highly rated or if possible replacement funds also will be paying distributions. Incorporating mutual fund distribution information into the investment process is very difficult for most investors because it requires a significant amount of research and analysis to make an informed investment decision. The potential tax consequences of selling a fund, and those of staying invested in the fund, are not the same for all investors, because cost basis and tax rates differ widely. Our tax-aware investment managers consider all these attributes on a customized basis for our clients. 5. Invest in Municipal Bond Funds or ETFs Asset allocation decisions (e.g., how much to invest in stocks, bonds, or shortterm investments) are arguably the most important decisions that an investment manager can make. Our asset allocation strategies take a client s federal and state tax rates into account by including municipal bonds and other asset classes, as appropriate, to seek desirable after-tax results. 15 For clients in high tax brackets, municipal securities may be beneficial because they typically generate income free from federal taxes and, in some cases, also free from state taxes. Widespread availability of municipal bond funds has enabled many individual investors to benefit from this tax-sensitive investment management strategy. If appropriate, our tax-aware investment managers also incorporate municipal bond funds into client portfolios, drawing on the extensive analysis of our in-house research team. Though distributions from mutual funds can vary widely from year to year, one study 16 estimates there were $213B in 2009 total combined distributions. At Strategic Advisers, our proprietary research group monitors the funds we hold, enabling us to estimate upcoming distributions and their tax impact to our clients. If a fund is poised to distribute a large gain, we may sell out of the fund or delay its purchase, thereby avoiding a tax liability. 9

10 Other Possible Tax-Saving Strategies For clients whose taxable savings are already professionally managed with tax sensitivity, there are other strategies to consider. One such strategy is donating securities with longterm appreciation to charitable organizations. When compared with cash contributions, gifts of these appreciated securities can result in an even bigger tax benefit to the donor. This is because donors not only avoid selling a security and realizing a capital gain, but they also get an itemized tax deduction for the appreciated value of the security. 17 The more highly appreciated the security, the higher the potential benefit to the investor. To encourage charitable giving of securities, the IRS also allows the offsetting of a significant portion of income (up to 30% of adjusted gross income), 18 so itemized charitable deductions can potentially reduce an individual s marginal tax rate. Conclusion Tax-sensitive investment management techniques can potentially deliver significant tax savings in a wide range of markets. However, it can be challenging and time consuming for an individual investor to implement most tax-sensitive investment management techniques on an ongoing basis. Tax-sensitive investment management is a service we provide to help Fidelity Personalized Portfolios clients take advantage of the strategies that seek to enhance their after-tax returns. Historical data tells a compelling story when it comes to the benefits of tax-sensitive investment management techniques. Over the period for which measurement is available, Fidelity has seen anywhere from 0.29% to 1.91% annual tax alpha added to clients portfolios (see Exhibit 2). The impact of these tax savings cumulatively over a decade or more can be very significant and it s evident that investing with a clear understanding of taxes matters. For more information, please contact your Fidelity Representative at

11 APPENDIX A: PERFORMANCE DETAILS Absolute s as of 12/31/ Year 5 Year 10 Year Life of Reporting (since 12/31/2001) Composite Benchmark Excess Composite Benchmark Excess Composite Benchmark Excess Composite Benchmark All-Stock Strategy Pre-tax 8.92% 10.26% 1.34% 11.05% 12.22% 1.17% 4.48% 5.33% 0.85% 5.63% 6.58% 0.95% All-Stock Strategy After Tax 9.48% 9.69% 0.21% 10.87% 11.17% 0.29% 5.75% 4.38% 1.36% 6.75% 5.79% 0.96% Tax Alpha 1.13% 0.88% 2.21% 1.91% Aggressive Strategy Pre-tax 7.71% 8.85% 1.13% 9.56% 10.97% 1.41% 4.15% 5.38% 1.22% 5.08% 6.42% 1.35% Aggressive Strategy After Tax 8.12% 6.77% 1.35% 9.19% 10.41% 1.22% 5.20% 4.71% 0.49% 6.00% 5.85% 0.14% Tax Alpha 2.49% 0.19% 1.71% 1.49% Growth Strategy Pre-tax 6.91% 7.33% 0.42% 8.36% 9.45% 1.08% 4.04% 5.10% 1.06% 4.85% 5.97% 1.12% Growth Strategy After Tax 7.25% 5.63% 1.62% 8.07% 8.99% 0.92% 4.80% 4.51% 0.29% 5.50% 5.48% 0.01% Tax Alpha 2.04% 0.16% 1.35% 1.13% Growth w/ Income Strategy Pre-tax 6.09% 6.34% 0.24% 7.59% 8.56% 0.97% 4.00% 5.04% 1.04% 4.86% 5.87% 1.01% Growth w/ Income Strategy After Tax 6.33% 4.88% 1.45% 7.32% 8.21% 0.88% 4.63% 4.52% 0.11% 5.37% 5.44% 0.07% Tax Alpha 1.70% 0.09% 1.15% 0.94% Balanced Strategy Pre-tax 5.08% 5.33% 0.25% 6.60% 7.50% 0.90% 3.72% 4.75% 1.03% 4.38% 5.41% 1.03% Balanced Strategy After Tax 5.23% 4.02% 1.22% 6.36% 7.22% 0.86% 4.21% 4.29% 0.08% 4.80% 5.07% 0.27% Tax Alpha 1.46% 0.05% 0.96% 0.76% Conservative Strategy Pre-tax 1.25% 2.28% 1.03% 3.49% 4.13% 0.64% 2.45% 3.55% 1.10% 3.22% 3.97% 0.75% Conservative Strategy After Tax 1.15% 1.52% 0.37% 3.28% 4.07% 0.80% 2.79% 3.30% 0.51% 3.38% 3.84% 0.45% Tax Alpha 0.66% 0.16% 0.59% 0.29% Excess Performance shown represents past performance, which is no guarantee of future results. Investment return and principal value of investments will fluctuate over time. A client s underlying investments may differ from those of the composite portfolio. s for individual clients may differ significantly from the composite returns and may be negative. Current performance may be higher or lower than returns shown. Composite and after-tax benchmark returns are asset weighted because both are based on individual client accounts. Pre-tax benchmarks are not asset weighted, because they are based on market indexes. s include changes in share price and reinvestment of dividends and capital gains. The index performance includes the reinvestment of dividends and interest income. An investment cannot be made in an index. Securities indexes are not subject to fees and expenses typically associated with managed accounts or investment funds. The underlying funds in each composite portfolio may not hold all the component securities included in, or in the same proportion as represented in, its corresponding customized benchmark. Only Fidelity Personalized Portfolios that are all stock or include national and state-specific municipal bond funds are included. Availability of state-specific funds depends on client s state of residence. Fidelity Personalized Portfolios ( FPP ) launched July 2010; performance before such date reflects only Fidelity Private Portfolio Service ( PPS ) accounts. See endnote 10 for more information on how these returns and benchmarks are calculated. The results in Appendix A represent average annual composite returns (net of fees) for FPP client accounts managed by Strategic Advisers that use an all-stock strategy or a strategy with municipal bond funds. Non-fee-paying accounts may be included in composites. This may increase the overall composite performance with respect to the net-of-fees performance. The pre-tax benchmarks consist of market indexes. The after-tax benchmarks consist of mutual funds, because an investable asset with known tax characteristics is needed to calculate after-tax benchmark returns for comparison. Composite portfolio excess returns are the difference between composite portfolio returns and their applicable composite portfolio benchmark returns. Both the pre-tax and after-tax composite portfolio benchmark returns are blended from either representative market indexes (for pre-tax benchmarks) or representative mutual funds (for after-tax benchmarks) in weightings based on the long-term asset allocation of each strategy. The benchmark returns are calculated monthly based on the long-term asset allocation of the strategies at that time so the benchmarks reflect historical changes to the asset allocation of each strategy. The benchmark long-term allocation weightings may vary slightly from individual client accounts due to individual account investments and activity. The tables on the next page detail the current composition of the benchmarks for each of the investment strategies that are all stock or with a municipal bond fund component mentioned in this paper. 11

12 APPENDIX B: COMPOSITION OF BENCHMARKS Pre-tax Benchmark Composition (as of 12/31/2016) Investment Strategy Dow Jones U.S. Total Stock Market Index MSCI ACWI ex USA Index (Net MA Tax) Bloomberg Barclays Municipal Bond Index Lipper Tax-Exempt Money Market Funds Index All Stock 70% 30% Aggressive 60% 25% 15% Growth 49% 21% 25% 5% Growth with Income 42% 18% 35% 5% Balanced 35% 15% 40% 10% Conservative 14% 6% 50% 30% All indexes are unmanaged and are not illustrative of any particular investment. Investments cannot be made directly in any index. Performance of the indexes includes reinvestment of dividends and interest income, unless otherwise noted. The domestic stock pre-tax benchmark component of all strategies is the Dow Jones U.S. Total Stock Market Index, a float-adjusted market capitalization weighted index of all equity securities of U.S.-headquartered companies with readily available price data. The foreign stock pre-tax benchmark component of all strategies is the Morgan Stanley Capital International All-Country World Index (MSCI ACWI ex USA Index [net MA tax]), a free-float-adjusted, market capitalization weighted index designed to measure the equity market performance of developed and emerging markets. The index returns for periods after 1/1/1997 are adjusted for tax withholding rates applicable to U.S.-based mutual funds organized as Massachusetts business trusts. The fixed income pre-tax benchmark component of all strategies with municipal bonds is the Bloomberg Barclays Capital Municipal Bond Index, a market value weighted index of investment-grade municipal bonds with maturities of one year or more. The short-term pre-tax benchmark component of all strategies with municipal bonds is the Lipper Tax-Exempt Money Market Funds Index, an unmanaged index consisting of the largest (assets) 30 funds within the tax-exempt money market discipline and is equal weighted and adjusted for capital gains and income. After-Tax Benchmark Composition (as of 12/31/2016) Investment Strategy Spartan Total Market Index Fund Fidelity Advantage Class (FSTVX) Spartan Global ex U.S. Index Fund Fidelity Advantage Class (FSGDX) ishares National Municipal Bond ETF (MUB) Fidelity Government Cash Reserves* (FDRXX) All Stock 70% 30% Aggressive 60% 25% 15% Growth 49% 21% 25% 5% Growth with Income 42% 18% 35% 5% Balanced 35% 15% 40% 10% Conservative 14% 6% 50% 30% The components of the after-tax benchmarks are mutual funds. The after-tax benchmark uses mutual funds as investable alternatives to market indexes in order to provide a benchmark that takes into account the associated tax consequences of these investable alternatives. Detailed information on these mutual funds is available on Fidelity.com. *The after-tax money market component of the benchmark changed to the Fidelity Government Cash Reserves Fund effective March 31, For accounts in a muni strategy, the previous fund was the Fidelity Tax-Exempt Treasury Money Market Fund. For accounts not in a muni strategy, the previous fund was the Fidelity Treasury Only Money Market Fund. 12 FIDELITY INVESTMENTS Portfolio Advisory Services

13 ENDNOTES Fidelity Private Portfolio Service is no longer available to investors. 1 Strategic Advisers, Inc. (SAI), applies tax-sensitive investment management techniques in Fidelity Personalized Portfolios and Fidelity Personalized Portfolios for Trusts (including tax-loss harvesting ) on a limited basis, at its discretion, solely with respect to determining when assets, including tax-exempt assets, in a client s account should be bought or sold. As a discretionary investment manager, SAI may elect to sell assets in an account at any time. A client may have a gain or loss when assets are sold. SAI does not currently invest in tax-deferred products, such as variable insurance products, or in tax-managed funds in Fidelity Personalized Portfolios or Fidelity Personalized Portfolios for Trusts, but may do so in the future if it deems such to be appropriate for a client. SAI does not actively manage for alternative minimum taxes; state or local taxes; foreign taxes on non-u.s. investments; or estate, gift, or generation-skipping transfer taxes. SAI relies on information provided by clients in an effort to provide tax-sensitive management and does not offer tax advice. SAI can make no guarantees as to the effectiveness of the tax-sensitive management techniques applied in serving to reduce or minimize a client s overall tax liabilities or as to the tax results that may be generated by a given transaction. Except where Fidelity Personal Trust Company, FSB, is serving as trustee, Fidelity Personalized Portfolios clients are responsible for all tax liabilities arising from transactions in their accounts, for the adequacy and accuracy of any positions taken on tax returns, for the actual filing of tax returns, and for the remittance of tax payments to taxing authorities. 2 The tax-sensitive investment management strategies described in this paper apply only to Fidelity Personalized Portfolios accounts. An assumption of this paper is that investors want to accumulate tax-loss carryforwards through the use of ongoing tax-sensitive investing strategies. Unused tax-loss carryforwards can generally be carried forward indefinitely to offset future realized capital gains and some ordinary income, but at death they do not carry over or pass down to a surviving heir. 3 Taxes can significantly reduce returns data, Morningstar, Inc. 3/1/2014. Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No state income taxes are included. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate. Although bonds generally present less short-term risk and volatility than stocks, bonds do entail interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), issuer credit risk, and the risk of default, or the risk that an issuer will be unable to make income or principal payments. The effect of interest rate changes is usually more pronounced for longer-term securities. Additionally, bonds and short-term investments entail greater inflation risk, or the risk that the return of an investment will not keep up with increases in the prices of goods and services, than stocks. 4 Tax alpha is a measure of value that an investment manager provides in helping improve after-tax returns using tax-sensitive investment management strategies. Tax alpha is calculated by subtracting the annualized pre-tax benchmark relative return (pre-tax excess return) from the annualized after-tax benchmark relative return (aftertax excess return). 5 After-Tax Excess : This number represents the amount the annualized percentage after-tax return for the portfolio or composite is above or below the comparable annualized after-tax benchmark return. Essentially, it shows by how much the after-tax return beat or trailed its benchmark. 6 Pre-tax Excess : This number represents the amount the annualized percentage pre-tax return for the portfolio or composite is above or below the comparable annualized pre-tax benchmark return. Essentially, it shows by how much the pre-tax return beat or trailed its benchmark. 7 Tax alpha is a measure of value that an investment manager provides in helping improve after-tax returns using tax-sensitive investment management strategies. Tax alpha is calculated by subtracting the annualized pre-tax benchmark relative return (pre-tax excess return) from the annualized after-tax benchmark relative return (after-tax excess return). 8 Cumulative Added from Tax-Sensitive Investment Management: This number represents the hypothetical value added from tax-sensitive investment management strategies that would have accrued on a $1 million investment in a composite of client accounts for each strategy during the stated time period. Essentially, it shows the cumulative tax alpha in terms of percentages. 9 The Pre-tax and After-Tax Composite Portfolios for all strategies (except the Moderate and Moderate with Income Strategies) were created on 12/31/2001. The After-Tax Composite Benchmark for strategies using municipal bond funds and the All Stock strategy were also created on 12/31/2001. For comparison purposes, the Pre-tax Benchmark uses the same creation date as the composites returns. This date signifies when a representative number of accounts were being managed to enable the composite calculation. s less than one year are cumulative. Calculation of Pre-tax Composite Portfolio s. Pre-tax Composite Portfolio s represent the asset-weighted composite performance of PPS and Personalized Portfolios client accounts managed to the indicated asset allocation strategy. Personalized Portfolios accounts were launched in July Performance prior to that date is only that of the PPS accounts. Composite performance is based on the returns of the following accounts: (1) PPS and PPS Trust client accounts during the time periods they were active, eligible, and over $50,000 since August 1, 2009 ($100,000 prior to 8/1/2009), and (2) the managed portion of Personalized Portfolios accounts that were active and eligible and over $5,000 since July As of May 31, 2012, all existing PPS accounts were converted to Personalized Portfolios. Performance after this date is based only on the managed portion of Personalized Portfolios accounts active and eligible and over $5,000; assets in the liquidity sleeve of Personalized Portfolios accounts have been excluded from composite performance. After July 1, 2015, the composite includes all eligible, active Personalized Portfolios accounts in amounts over $50,000. The liquidity sleeve is established to meet client-directed cash flow instructions, including withdrawals and gradual investment, and contains short-term positions including money market funds. Accounts must have at least one full calendar month of returns to be included in the composite. Accounts subject to significant investment restrictions provided by clients are excluded from composites. In limited circumstances, additional accounts with nonstandard characteristics are excluded from composites. Accounts with a do-not-trade restriction are removed from the composite once the restriction has been on the account for 65 days. Accounts for which clients provided short-term and long-term tax rates of zero are also excluded from the composite. Client account performance is calculated using time-weighted methodology, which minimizes the effect of cash flows in and out of accounts and related impacts to account returns during the period. Pre-tax composite portfolio returns are calculated using asset-weighted methodology, which takes into account the differing sizes of client accounts (e.g., considers larger and smaller accounts proportionately). Performance shown is net of the actual investment management fees paid by each client, including net of any fee credits applicable to the account, as well as net of any underlying fund expenses. Investors should note that while the gross advisory fees charged to PPS accounts are generally higher (1.70% of assets under management for the smallest accounts in the program), Fidelity Personalized Portfolios accounts operate under a different fee structure, which includes additional fees for certain services, including separate fees for investment in separately managed account sleeves offered within the Fidelity Personalized Portfolios program. Accordingly, the net advisory fees paid by Fidelity Personalized Portfolios customers may be more variable than those paid by PPS customers, and may be higher or lower than those experienced in past periods for PPS customers. Individual client accounts will vary and are based on their individual tax and investment situations and, therefore, performance may be better or worse than the performance shown. s include changes in share price and reinvestment of dividends and capital gains, if applicable. Larger accounts may, by percentage, pay lower management fees than smaller accounts. Fees for each program are fully described in the PPS and Fidelity Personalized Portfolios introductory materials (as applicable) and in individual fund prospectuses utilized by the program. Please read these materials before investing. Pre-tax Composite Portfolio Benchmark s are hypothetical measures showing how the combination of certain indexes would have performed based on weightings for the portfolio s long-term asset allocation, and do not indicate the actual performance results of a managed portfolio of funds, past or future, nor do they reflect PPS s and Fidelity Personalized Portfolios fees or individual fund sales charges or fund expenses. Unlike the Pre-tax and After-Tax Composite Portfolios and the After-Tax Composite Benchmark, which are asset weighted because they are composed of client-specific data, the Pre-tax Composite Benchmark is not asset weighted because it does not contain client-specific data. Portfolio benchmarks, whether pre-tax or after-tax, and their underlying indexes may be changed from time to time by the SAI Investment Management Team. 13

14 ENDNOTES Calculation of After-Tax Composite Portfolio s. After-tax Composite Portfolio s represent the asset-weighted composite performance of PPS and Personalized Portfolios client accounts managed to the indicated asset allocation strategy. Personalized Portfolios accounts were launched in July Performance prior to that date is only that of the PPS accounts. Composite performance is based on the returns of the following accounts: (1) PPS and PPS Trust client accounts during the time periods they were active, eligible, and over $50,000 since August 1, 2009 ($100,000 prior to 8/1/2009), and (2) the managed portion of Personalized Portfolios accounts that were active and eligible and over $5,000 since July As of May 31, 2012, all existing PPS accounts were converted to Personalized Portfolios. Performance after this date is based only on the managed portion of Personalized Portfolios accounts active and eligible and over $5,000; assets in the liquidity sleeve of Personalized Portfolios accounts have been excluded from composite performance. After July 1, 2015, the composite includes all eligible, active Personalized Portfolio accounts in amounts over $50,000. The liquidity sleeve is established to meet client-directed cash flow instructions, including withdrawals and gradual investment, and contains short-term positions including money market funds. Accounts must have at least one full calendar month of returns to be included in the composite. Accounts subject to significant investment restrictions provided by clients are excluded from composites. In limited circumstances, additional accounts with nonstandard characteristics are excluded from composites. Accounts with a do-not-trade restriction are removed from the composite once the restriction has been on the account for 65 days. Accounts for which clients provided short-term and long-term tax rates of zero are also excluded from the composite. Client account performance is calculated using time-weighted methodology, which minimizes the effect of cash flows in and out of accounts and related impacts to account returns during the period. After-tax composite portfolio returns are calculated using asset-weighted methodology, which takes into account the differing sizes of client accounts (e.g., considers larger and smaller accounts proportionately). Individual client accounts will vary based on their individual tax and investment situations and, therefore, performance may be better or worse than the performance shown. Performance shown is net of the actual investment management fees paid by each client, including net of any fee credits applicable to the account, as well as any underlying fund expenses, and reflects reinvestment of any interest, dividends, and capital gains distributions. These are manually reinvested, but not necessarily into the issuing fund. Investors should note that while the gross advisory fees charged to PPS accounts are generally higher (1.70% of assets under management for the smallest accounts in the program), Fidelity Personalized Portfolios accounts operate under a different fee structure, which includes additional fees for certain services, including investment in separately managed account sleeves offered within the Fidelity Personalized Portfolios program. Accordingly, the net advisory fees paid by Fidelity Personalized Portfolios customers may be more variable than those paid by PPS customers, and may be higher or lower than those experienced in past periods for PPS customers. Mutual fund redemption fees that would otherwise apply are currently paid by PPS. Individual client accounts will vary and performance may be more or less than the performance shown. s include changes in share price and reinvestment of dividends and capital gains, if applicable. Larger accounts may, by percentage, pay lower management fees than smaller accounts. Fees are fully described in the PPS and Fidelity Personalized Portfolios introductory materials (as applicable) and in individual fund prospectuses. Please read these materials before investing. Assumptions Underlying After-Tax Composite Portfolio s. The following assumptions have been used as part of the After-Tax Composite Portfolio s calculations: All distributions of qualified dividend income are assumed to meet the required holding period. In most cases, specific ID cost-basis methodology rather than average cost basis is applied when managing client accounts. Performance and rates of return are calculated net of the payment of the quarterly advisory fee on client accounts. s are calculated net of the payment of underlying mutual fund expenses as described in individual fund prospectuses. Individual share price and returns will vary, and you may have a gain or loss when your shares are sold. Performance, whether reported on a pre-tax or after-tax basis, includes accrued interest for the following securities: fixed-rate bonds, fixed-rate government bonds, and commercial paper. Other securities are computed on a cash basis only, so, for example, accrued interest on money market funds, mutual funds, and accrued dividends on equities are not included in the calculation. For accounts with individual bonds, amortization and accretion for bonds are not included in performance calculations. After-tax composite portfolio returns are calculated based on a daily valuation time-weighted methodology estimating the impact of federal ordinary income taxes, Medicare surtaxes, and the alternative minimum tax where customers have indicated this applies. If accounts migrated from PPS, the accounts were calculated in some historical months using a modified Dietz method or, depending on the relative size of cash flows, a daily valuation method, taking into consideration the impact of federal income taxes, based on the activity in client accounts. After-Tax Composite Portfolio s are calculated by adjusting for actual transactions (sales, dividend earnings, etc.) that have taken place in the accounts, and by assuming that (i) each category of income is taxed at individual marginal rates in effect for the period in which the taxable transaction took place and is computed based on long-term capital gains rate and marginal income tax rate information provided by the client, and (ii) cost-basis and holding period information provided by the client is accurate. Cost-basis information provided in customer communications may not reflect all adjustments to such information that may be necessary due to events outside the control of, or unknown to, Fidelity (e.g., wash sales resulting from purchases and sales of securities in other non-managed accounts). Such after-tax returns take into account the effect of federal income taxes only; taxes other than federal income taxes, including alternative minimum taxes, state and local taxes, foreign taxes on non-u.s. investments, and estate, gift, and generation-skipping transfer taxes, are not taken into account. Any realized short-term or long-term capital gain or loss retains its character in the after-tax calculation. The gain/loss for any account is applied in the month incurred and there is no carry-forward. We assume that losses are used to offset gains realized outside the account in the same month, and we add the imputed tax benefit of such a net loss to that month s return. This can inflate the value of the losses to the extent that there are no items outside the account against which they can be applied. We assume that taxes are paid from outside the account. Taxes are recognized in the month in which they are incurred. This may inflate the value of some short-term losses if they are offset by long-term gains in subsequent months. Any year-end adjustments for dividends, with respect to classifications as qualified versus nonqualified, are not taken into account. After-Tax Composite s do not take into account the tax consequences associated with income accrual, deductions with respect to debt obligations held in client accounts, or federal income tax limitations on capital losses. After-Tax Composite Portfolio s may exceed pre-tax returns as a result of an imputed tax benefit received upon realization of tax losses. Withdrawals from client accounts during the performance period result in adjustments to take into account unrealized capital gains across all securities in such account, as well as the actual capital gains realized on the securities. Changes in laws and regulations may have a material impact on pre-tax and/or after-tax investment results. Strategic Advisers, Inc. (SAI), relies on information provided by clients in an effort to provide tax-sensitive investment management, and does not offer tax advice. SAI can make no guarantees as to the effectiveness of the tax-sensitive investment management techniques applied in seeking to reduce or minimize a client s overall tax liabilities or as to the tax results that may be generated by a given transaction. Consult your tax advisor for additional details. The After-Tax Composite Portfolio Benchmark s represent an asset-weighted composite of clients individual after-tax benchmark returns. Each client s personal after-tax benchmark is composed of mutual funds (index funds where available) in the same asset class percentages as the client s investment strategy and differs from the composition of the pre-tax benchmark presented above, which is composed of a combination of broad market indexes. The after-tax benchmark uses mutual funds as investable alternatives to market indexes in order to provide a benchmark that takes into account the associated tax consequences of these investable alternatives. They assume reinvestment of dividends and capital gains, if applicable. The after-tax benchmark also takes into consideration the tax impact of rebalancing the benchmark portfolio, assuming the same tax rates as are applicable to each client s account, as well as an adjustment for the level of unrealized gains in each account. The After-Tax Composite Portfolio Benchmark return is calculated assuming the use of the average cost basis method for calculating the tax basis of mutual fund shares. All indexes are unmanaged and include reinvestment of interest and/or dividends. Please note that an investor cannot invest directly in an index. The performance data featured represents past performance, which is no guarantee of future results. Investment return and principal value of an investment will fluctuate. Current performance may be higher or lower than the performance data quoted. 14 FIDELITY INVESTMENTS Portfolio Advisory Services