Portfolio Construction for Taxable Investors

Portfolio Construction for Taxable Investors

Scott J. Donaldson, CFA,CFP, and Frank A. Ambrosio, CFA, Vanguard Investment Counseling & Research (2007)

Executive summary. Most investment portfolios are designed to meet a specific future financial need—either a single goal or a multifaceted set of objectives. To reach those goals and objectives, a disciplined method of portfolio construction must be established that balances the potential risks and returns of various types of investments. This paper reviews various aspects of our research involving five major investment decisions that need to be made, in successive order, in the portfolio construction process. The decisions are:

Asset allocation—Choosing asset-class weights: equities, fixed income, cash, and so on.

Sub-asset allocation—Choosing investments within an asset class, such as U.S. or international equities; or large-, mid-, or small-capitalization equities.

Active and/or passive allocations—Choosing indexed and/or actively managed assets.

Asset location—Deciding on the placement of investments in taxable and/or tax-advantaged accounts.

Manager selection—Choosing individual managers, funds, or securities to fill allocations.

The top-down order in which these decisions are made is important in establishing a well-constructed portfolio. Many investors use a bottom-up approach, placing more emphasis on manager/security selection or sub-asset allocation (based on an investment’s recent returns) than on asset allocation, the most important portfolio decision. However, in using a bottom-up approach, the selection of the investments—potentially the more uncertain part of portfolio construction—would then determine the more important part—the overall asset allocation. After deciding the asset allocation of the portfolio, it is important to keep in mind that broad diversification, with exposure to all parts of the stock and bond markets, is a powerful strategy for managing portfolio risk. Diversification across asset classes reduces a portfolio’s exposure to the risks common to an entire asset class. Diversification within asset classes reduces a portfolio’s exposure to the risks associated with a particular company, sector, or market. This diversification can be achieved through index and/or actively managed investment strategies. The decision to purchase certain investments within either tax-advantaged and/or taxable accounts, known as asset location, is a valuable tool to increase potential after-tax returns. This can be achieved by placing tax efficient assets in taxable accounts and tax inefficient assets in tax-advantaged accounts. Selecting specific investments to represent the various market segments should come last. A common error in portfolio construction is that of choosing specific investments that may appear to be worthwhile individually, but make little sense when combined in a portfolio. In the end, this collection of investments does not necessarily form a coherent asset allocation or sub-asset allocation that matches the investor’s objectives and risk tolerance.

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Asset Location: Variable Annuities

Household Demand for Variable Annuities

Brown, Jeffrey R. and Poterba, James M., "Household Demand for Variable Annuities" (March 2004). Boston College, Center for Retirement Research Working Paper No. 2004-08.

Abstract:

Between 1990 and 2000, total sales of variable annuities in the U.S. grew from just over $5 billion to nearly $140 billion. These products now account for approximately half of all private market annuity sales. Variable annuities resemble mutual funds, but they qualify for special tax treatment as insurance products because they provide an option to convert to a life annuity. This paper describes the tax treatment of variable annuities and presents summary information on the ownership patterns for variable annuities. It also explores the relative importance of several distinct motives for household purchase of variable annuities. We use household data from the 1998 and 2001 waves of the Survey of Consumer Finances to examine ownership patterns and to test for the importance of tax and insurance considerations in variable annuity demand. We find that variable annuity ownership is highly concentrated among high income and high net wealth sub-groups of the population, although the concentration is lower than for several other categories of financial assets. We find mixed support for the role of tax considerations in generating variable annuity demand, and we outline a set of research issues that focus on household annuity purchases.

The Titanic Option: Valuation Of The Guaranteed Minimum Death Benefit In Variable Annuities And Mutual Funds

Milevsky, Moshe and Posner, Steven E.,The Journal of Risk and Insurance, 2001, Vol. 68, No. 1, 91-126.

ABSTRACT

The authors use risk-neutral option pricing theory to value the guaranteed minimum death benefit (GMDB) in variable annuities (VAs) and some recently introduced mutual funds. A variety of death benefits, such as returnof- premium, rising floors, and “ratches,” are analyzed. Specifically, the authors compute the fair insurance risk fee, charged to assets, that funds the embedded option. The authors derive analytic option prices for a simplified exponential mortality model and robust numerical estimates in the case of a properly calibrated Gompertz model. The authors label this contingent claim a Titanic option because its payoff structure is in between European and American style but is triggered by death. The authors’ main objective is to compare theoretical estimates against a cross-section of insurance risk charges, as reported by Morningstar, Inc. The authors’ main conclusion is that a simple return-of-premium death benefit is worth between one and ten basis points, depending on gender, purchase age, and asset volatility. In contrast, the median Mortality and Expense risk charge for return-of-premium variable annuities is 115 basis points. Presumably, the remaining markup can be attributed to profits, model imperfections, or, more cynically, to an implicit payment for the tax-deferral privilege.

Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options

Milevsky, M.A. and Panyagometh, Kamphol, "Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options" (September 2001). York-Schulich-Finance Working Paper No. MM10-1.

Abstract:

This paper quantifies the impact of return uncertainty when measuring the relative benefits of mutual funds versus variable annuities by calculating the certainty equivalents of utility. This paper points out that the possibility of an investment loss endows the holder of the mutual fund with a 'real option' to harvest those losses and this 'real option' has value and must be factored into any decision in advance.

Our main practical observation is that although we find that low-cost Variable Annuities are indeed superior to low-cost Mutual Funds for investors with a long time horizon, the critical threshold is at least 10 years for typical levels of risk aversion. If, however, we ignore the embedded options, the erroneous break-even horizon drops to 5 years. The stochasticity increases the break-even horizon.

Asset Allocation and Asset Location

The following papers examine the optimal division of asset classes between taxable and tax preferenced accounts. A fine tool for determining asset location can be found at Easy Allocator.

Maximizing Long-Term Wealth Accumulation:It’s Not Just About "What" Investments To Make,But Also "Where" To Make Them

Robert M. Dammon, Carnegie Mellon University
James Poterba, Massachusetts Institute of Technology
Chester S. Spatt, Carnegie Mellon University
Harold H. Zhang, University of Texas at Dallas

EXECUTIVE SUMMARY

Individuals who are saving for retirement are likely to know that the level of savings and the asset allocation of their savings are two very important factors affecting wealth accumulation. Another factor called asset location — which refers to the placement of certain types of assets in tax-deferred accounts and other types of assets in taxable accounts — is far less understood
The winners of the 2004 TIAA-CREF Paul A. Samuelson Award tackled this issue head-on, and concluded that equities are far better suited for taxable accounts than for tax-deferred accounts, and that bonds are far better suited for tax-deferred accounts than for taxable accounts. The reason for this preference is the different tax treatment of equity investments compared to fixed-income investments. Other research findings include:

• Choosing the right asset location for a pair of asset classes is more important when the tax rate differential between the two types of assets is greater and when the rate of return on the relevant assets is high.
• The relative proportions of taxable and tax-deferred wealth are an important factor in determining one’s optimal asset allocation. According to the Samuelson award-winning authors, other factors being equal, an investor’s optimal equity allocation will be higher when a larger proportion of his/her total wealth is held in taxable accounts, and that his/her optimal bond allocation will be higher if the bulk of his/her wealth is held in tax-deferred accounts.
• The ideal situation occurs when the desired asset allocation is reached by investing the entire tax deferred account in bonds and the entire taxable account in equities. More often, the proportions of financial assets don’t match up neatly with the desired asset allocations, and so adjustments may be needed. The authors state that for maximum tax efficiency, individuals should not hold mixed portfolios of equities and bonds in both their taxable and tax-deferred accounts.

Tax Efficient Saving and Investing

By William Reichenstein, Ph.D.,
TIAA-CREF Institute Fellow, Baylor University
February 2006

EXECUTIVE SUMMARY

A central component of investment advice in recent decades both for individual and institutional investors has focused on asset allocation, and rightly so since it plays a critical role in determining returns. For individual investors, tax management also plays a significant role in maximizing wealth but it typically does not receive the attention it deserves. This Trends and Issues examines four types of tax considerations that can reap benefits to investors:

• Choice of Savings Vehicle. To the degree possible, individuals should take maximum advantage of tax-favored savings vehicles, including tax-deferred accounts such as 401(k)s, 403(b)s and traditional IRAs, as well as after-tax accounts such as Roth IRAs, Roth 401(k)s, and Roth 403(b)s. All of these accounts essentially allow for tax-exempt growth on their after-tax values.

• After-Tax Asset Allocation. As noted, most individuals are aware of the importance of asset allocation but they calculate it as though assets in tax-deferred accounts are worth the same amount as those in taxable accounts. As a result, they overstate the allocation to the dominant asset class held in tax-deferred accounts. When calculating their asset allocation, they should convert all assets to after-tax values and then calculate their asset allocation using these after-tax values. For example, assets in tax-deferred accounts should be converted to after-tax funds by multiplying the pretax value by 1 minus the expected tax rate during retirement. Sometimes assets in taxable accounts also need to be converted to after-tax values, but the adjustments generally are not as large.
• Tax-Efficient Investing (Including the Role of the Stock Management Style). Examples of tax-efficient investing in one’s taxable account include: a) tax-loss harvesting, in which capital losses are realized in order to offset capital gains or ordinary income; and, 2) passive, index-type investing where unrealized gains are allowed to accumulate, thus providing tax deferral and even exemption if assets ultimately receive a step-up in basis or are donated to charity.
• Asset Location. This concept refers to appropriate location of equities and fixed income. In general, fixed income should be held in retirement accounts such as 403(b)s and Roth IRAs and equities, especially passively-managed stocks, should be held in taxable accounts. The reason for this preference is that, when held in taxable accounts, equities are generally taxed more favorably than fixed income. Equities in taxable accounts can benefit from lower capital gains tax rates, and taxation on gains can be deferred as long as the investor continues to hold the equities. Taxation on gains can even be avoided altogether if the owner holds the equities until death, at which time they receive a step-up in basis. In addition, capital losses can offset capital gains and reduce income.

Non-qualified Annuities in After Tax Optimizations


William Reichenstein, Baylor University

Abstract

This study first explains why individuals should calculate an after-tax asset allocation. This asset allocation distinguishes between pretax funds in say a 401(k) and the generally after-tax funds in a taxable account. Separately, it performs mean-variance optimizations for individual investors. It concludes that, in general, almost all investors should locate bonds in Roth IRAs and qualified retirement accounts (e.g., 401(k)) and stocks, especially passively held stocks, in taxable accounts. At lower levels of risk tolerance, investors should substitute bonds held in non-qualified annuities for stocks held in taxable accounts. At higher levels of risk tolerance, they should substitute stocks for bonds held in Roth IRAs and qualified retirement accounts. The analysis suggests that the people who should be most interested in holding stocks in annuities are those who trade too frequently to qualify for preferential capital gain tax rates. Finally, this study may be the first to demonstrate that an individual investor bears more risk when an asset is held in an annuity instead of taxable account, and it considers the implications of this conclusion for optimal asset-allocation and asset-location decisions.