Asset location

Last updated

Asset location (AL) is a term used in personal finance to refer to how investors distribute their investments across savings vehicles including taxable accounts, tax-exempt accounts (e.g., TFSA, Roth IRA, ISAs, TESSAs), tax-deferred accounts (e.g., Canadian RRSP, American 401(k) and IRAs, British SIPPs, Irish Personal Retirement Savings Accounts (RPSA), and German Riester pensions), trust accounts (e.g., grantor retainer annuity trusts, generation-skipping trusts, charitable remainder trusts, charitable lead trusts), variable life insurance policies, foundations, and onshore vs. offshore accounts. [1]

Contents

While asset allocation (AA) determines what assets to own and in what proportions, AL determines where those assets are held. While the objective of AA is to create portfolios with the greatest return for a level of risk, and to optimize individuals' risk exposure according to their risk tolerance, goals and investment time frame, the objective of AL is to maximize the benefits of different account-types - usually to minimize taxes. There are other objectives that can be personal (e.g., the liquidity of the wealth, the expected use of the funds, privacy, etc.).

In the discussion below the effective tax rate for any asset depends on a personal tax bracket, different countries' treatment of different types of income, personal frequency of realizing the tax liability (e.g. capital gains only taxable when sold after a multi-year holding period), the mix of income-types generated by an asset, and the net tax effect that includes both tax debits and credits (e.g. the treatment of dividend income in Canada and Great Britain). [2]

Location Choice Methodology

Tax Rates

Although there is no academic support, it is common (now declining) to hear that assets with the highest effective tax rates should be prioritized in tax-shelter accounts. This will have been broadly appropriate over the 30 years from the 1980s to the 2000s in North America, as interest rates declined and debt's total returns matched the returns of equity. The rule is dependent on the assumption that total returns from different asset-types are equal. When interest rates are low and expected to rise that assumption will not be valid.

Tax Efficiency

Another common metric to decide which assets should be prioritized is tax-efficiency. [3] This equals the dollars of tax payable per principal invested - the multiple of the asset's rate of return by its effective tax rate. Another way to look at the same metric is as the difference between the asset's nominal rate of return and its after-tax rate of return.

This metric measures the tax-sheltering benefits of the first year only. Reed [4] finds that this metric fails over the life of the accounts. Given two assets with the same tax-efficiency, the asset with the larger rate of return will always create larger benefits in tax-exempt accounts. Even when a high-return asset has a lower tax-efficiency, given enough time it creates more benefits.

It is only when the effective tax rate is very low that its importance relative to the rate of return is equally strong or stronger.

Cumulative Benefit

Reed [5] calculates the cumulative tax savings over varying time spans from tax-free growth. For tax-deferred accounts there may be an additional bonus (or penalty) from a lower (or higher) tax rate on withdrawal vs. contribution. Assets with the largest benefits are given priority into tax shelters. He points out that re-balancing to some asset allocation will reduce the benefits from asset location.

He concludes that 'it all depends' and general rules of thumb are not valid. For example, given enough time high return assets create the largest benefits from tax-free growth, but there may not be enough time, or the high return asset may result in a portfolio large enough to create a penalty from higher withdrawal tax rates.

Asset Types

Common advice is to locate tax-inefficient assets (such as bonds and real estate investment trusts) in the tax-advantaged accounts. [6] This is to fully utilize any long-term capital gain, or capital gains allowances available in taxable accounts. Place income-generating investments into tax-deferred or non-taxable accounts, and place equity investments into taxable accounts. The deciding factor is apparently the effective tax rate on the asset's income.

For the same reason, tax-exempt bonds, national savings certificates and other similar tax-privileged securities are best located in fully taxable accounts. [7] Shoven and Sialm [8] provided an analysis of the decision point when income producing equities should be sheltered and optimal portfolio choice for each type of account. Individual stocks, passive index funds, or exchange-traded funds are generally regarded as tax-efficient and, consequently, better placed in taxable accounts, when more heavily taxed income generating assets, such as bonds, real estate investment trusts, and so on, are available for secretion in a tax sheltered location.

Actively managed mutual funds or unit trusts may also prove to be better located in tax-sheltered vehicles, because equities held through financial intermediaries tend to be taxed more, due to high turnover, than individual equities held by an investor for the long term, who has the opportunity to plan the realization of gains and offset losses. Siegel and Montgomery [9] demonstrate conclusively that taxes and inflation substantially dampen compound returns especially for equity investors.

An Alternate Model

William Reichenstein [10] proposes an alternate model. He ignores completely the tax-sheltering benefits of tax-deferred and tax-exempt accounts. His AL objective is not to maximize those benefits. He uses the AL to fine-tune the AA decision using mean-variance optimization (MVO) of Modern portfolio theory. MVO uses the means, variances, and co-variance matrix of all assets, along with a utility function to manage risk tolerances.

When assets are held in taxable accounts their after-tax means and variances will be smaller than for those in tax-shelter accounts. Reichenstein considers each asset-type to have a taxable variant and a tax-free variant, with their different metrics. The MVO process results in an optimal AA for both the taxable and the tax-free asset. The AL falls out from this conclusion.

Patterns of Behavior

Surveys of households have shown that there is often a gulf between where assets are located and where some people think they ought to be, to provide an optimal tax outcome. Reed's re-balancing model rarely shows a difference of more than 10% after 30 years, unless withdrawals from tax-deferred accounts are at lower rates. So it may be that households are correct. Amromin [11] argues that job income insecurity, penalties and restrictions on withdrawals from tax-deferred accounts explain why people are tax-inefficient with their investments. Employers’ matches in defined contribution retirement plans and the structure of the social security system also play a part in driving low tax equity investments into sheltered accounts. [12]

Bodie and Crane [13] studied TIAA-CREF participants and concluded that investors chose similar asset allocations in their taxable and tax-deferred accounts, with little apparent regard for the benefits of tax efficient asset location. Barber and Odean [14] surveyed brokerage records and found that more than half of the households held taxable bonds in their taxable accounts, despite available alternatives, and that the preference for holding equity mutual funds in retirement accounts appeared to be stronger than that for holding taxable bonds.

Other commentators suggest decisions concerning the use of home equity and mortgage debt as a substitute for consumer debt have driven choice of portfolio location. [15] An idealized example shows that over a 25-year interval, the difference between extreme asset location choices yielded a compounded 18% differential in return. [16]

See also

Related Research Articles

A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV in Europe and open-ended investment company (OEIC) in the UK.

<span class="mw-page-title-main">Personal finance</span> Budgeting and expenses

Personal finance is the financial management which an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial risks and future life events.

A capital gains tax (CGT) is the tax on profits realized on the sale of a non-inventory asset. The most common capital gains are realized from the sale of stocks, bonds, precious metals, real estate, and property.

A registered retirement savings plan (RRSP), or retirement savings plan (RSP), is a type of financial account in Canada for holding savings and investment assets. RRSPs have various tax advantages compared to investing outside of tax-preferred accounts. They were introduced in 1957 to promote savings for retirement by employees and self-employed people.

A personal equity plan (PEP) was a form of tax-privileged investment account in the United Kingdom, available between 1986 and 1999.

Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. Examples of tax-advantaged accounts and investments include retirement plans, education savings accounts, medical savings accounts, and government bonds. Governments establish tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest.

<span class="mw-page-title-main">Collateralized debt obligation</span> Financial product

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.

An income trust is an investment that may hold equities, debt instruments, royalty interests or real properties. They are especially useful for financial requirements of institutional investors such as pension funds, and for investors such as retired individuals seeking yield. The main attraction of income trusts is their stated goal of paying out consistent cash flows for investors, which is especially attractive when cash yields on bonds are low. Many investors are attracted by the fact that income trusts are not allowed to make forays into unrelated businesses: if a trust is in the oil and gas business it cannot buy casinos or motion picture studios.

<span class="mw-page-title-main">Asset allocation</span> Investment strategy

Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.

In the United States, an annuity is a financial product which offers tax-deferred growth and which usually offers benefits such as an income for life. Typically these are offered as structured (insurance) products that each state approves and regulates in which case they are designed using a mortality table and mainly guaranteed by a life insurer. There are many different varieties of annuities sold by carriers. In a typical scenario, an investor will make a single cash premium to own an annuity. After the policy is issued the owner may elect to annuitize the contract for a chosen period of time. This process is called annuitization and can also provide a predictable, guaranteed stream of future income during retirement until the death of the annuitant. Alternatively, an investor can defer annuitizing their contract to get larger payments later, hedge long-term care cost increases, or maximize a lump sum death benefit for a named beneficiary.

A child trust fund (CTF) is a long-term savings or investment account for children in the United Kingdom. New accounts can no longer be created as of 2011, but existing accounts can receive new money: the accounts were replaced by Junior ISAs.

A wash sale is a sale of a security at a loss and repurchase of the same or substantially identical security shortly before or after. Losses from such sales are not deductible in most cases under the Internal Revenue Code in the United States. Wash sale regulations disallow an investor who holds an unrealized loss from accelerating a tax deduction into the current tax year, unless the investor is out of the position for some significant length of time. A wash sale can take place at any time during the year, or across year boundaries.

A venture capital trust or VCT is a tax efficient UK closed-end collective investment scheme designed to provide venture capital for small expanding companies, and income and/or capital gains for investors. VCTs are a form of publicly traded private equity, comparable to investment trusts in the UK or business development companies in the United States. They were introduced by the Conservative government in the Finance Act 1995 to encourage investment into new UK businesses.

Requires updating to reflect the current Income Tax Act and the growth of MICs that trade on the TSX.

Core & Satellite Portfolio Management is an investment strategy that incorporates traditional fixed-income and equity-based securities known as the "core" portion of the portfolio, with a percentage of selected individual securities in the fixed-income and equity-based side of the portfolio known as the "satellite" portion.

The following outline is provided as an overview of and topical guide to finance:

National Pension System Trust is a specialised division of Pension Fund Regulatory and Development Authority which is under the jurisdiction of Ministry of Finance of the Government of India. The National Pension System (NPS) is a voluntary defined contribution pension system in India. National Pension System, like PPF and EPF is an EEE (Exempt-Exempt-Exempt) instrument in India where the entire corpus escapes tax at maturity and entire pension withdrawal amount is tax-free.

<span class="mw-page-title-main">Retirement spend-down</span>

At retirement, individuals stop working and no longer get employment earnings, and enter a phase of their lives, where they rely on the assets they have accumulated, to supply money for their spending needs for the rest of their lives. Retirement spend-down, or withdrawal rate, is the strategy a retiree follows to spend, decumulate or withdraw assets during retirement.

Goals-Based Investing or Goal-Driven Investing is the use of financial markets to fund goals within a specified period of time. Traditional portfolio construction balances expected portfolio variance with return and uses a risk aversion metric to select the optimal mix of investments. By contrast, GBI optimizes an investment mix to minimize the probability of failing to achieve a minimum wealth level within a set period of time.

Dedicated portfolio theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds and/or other fixed income securities that can and usually are held to maturity to generate this predictable stream from the coupon interest and/or the repayment of the face value of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.

References

  1. ↑ Brunel, Jean. 2001. “Asset Location—The Critical Variable: A Case Study.” Journal of Wealth Management , vol. 4, no. 1 (Summer):27–43.
  2. ↑ Robert M. Dammon, Chester S. Spatt and Harold H. Zhang, “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing”, Journal of Finance, Vol. LIX, No. 3 June 2004.
  3. ↑ Boglehead Wiki, “Principles of Tax-Efficient Fund Placement”
  4. ↑ C.Reed, “Rethinking Asset Location - between tax-deferred, tax-exempt and taxable accounts”, August 2013.
  5. ↑ "Rethinking Asset Location"
  6. ↑ William W. Jennings and William Reichenstein, “The Literature of Private Wealth Management”, The Research Foundation of CFA Institute, 2006.
  7. ↑ James Poterba, John Shoven & Clemens Sialm, “Asset Location for Retirement Savers”, Chapter 10, Private Pensions and Public Policies
  8. ↑ John B. Shoven and Clemens Sialm, “Asset Location in Tax-Deferred and Conventional Savings Accounts”, NBER Working Paper No. 7192, June 1999, JEL No. G11,G23,H24
  9. ↑ Laurence B. Siegel and David Montgomery, “Stocks, Bonds, and Bills after Taxes and Inflation.” Journal of Portfolio Management, vol. 21, no. 2 (Winter 1995):17–25.
  10. ↑ William Reichenstein, “Asset Allocation and Asset Location Decisions Revisited”, Journal of Wealth Management, Summer 2001
  11. ↑ Gene Amromin, “Precautionary Savings Motives and Tax Efficiency of Household Portfolios:An Empirical Analysis”, in Tax Policy and the Economy, Volume 22, University of Chicago Press, July 2008
  12. ↑ Zhe Li, “Retirement Savings and Portfolio Choices in Taxable and Tax-Deferred Accounts”, Stony Brook University, September 2009
  13. ↑ Bodie, Zvi, and Dwight B. Crane. 1997. “Personal Investing: Advice, Theory and Practice.” Financial Analysts Journal, vol. 53, no. 6 (November/December):13–22
  14. ↑ Brad M. Barber and Terrance Odean, “Are Individual Investors Tax Savvy? Evidence from Retail and Discount Brokerage Accounts”, Forthcoming: Journal of Public Economics, October 2002. Archived May 6, 2012, at the Wayback Machine
  15. ↑ Dean Maki, “Portfolio Shuffling and Tax Reform”, National Tax Journal, Vol 49 no. 3 (September 1996) pp. 317-329. Archived September 28, 2011, at the Wayback Machine
  16. ↑ Daniel Bergstresser and James Poterba, “Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances”, NBER Working Paper No. 9268, October 2002, JEL No. H2, G2
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.