Helping Your Clients Execute a Tax-Aware Investment Plan

Tax practitioners play an essential role in successful outcomes.
By Stephen Riley and Richard Furmanski

There is one significant difference between high-net-worth individual investors and institutional pension investors: taxes! A majority of high-net-worth individuals have both taxable and tax-deferred accounts, while pension portfolio managers have no such burden. This makes optimizing high-net-worth client portfolios far more complex and argues for a number of tax-aware and portfolio management best practices that require expertise and insight more often associated with a tax professional than an investment adviser. Without a tax professional’s input, much of the benefit of tax-aware best practices is unlikely to be achieved.

In our Nov. 19, 2015, Tax Insider article, we discussed the planning phase of tax-aware and portfolio management best practices, also known as asset location management. In this article, we explore execution best practices, including tax-loss harvesting, realized gain budgeting, supportive tax-lot accounting, and finally the important work of helping clients maintain a long-term investment focus.

Most investment advisers find tax-aware best practices a challenge. Understanding, much less implementing these policies, requires a significant amount of time and ongoing effort. Tax-aware and portfolio management best practices often have negative implications for day-to-day investment advisory operations, including profitability. Implementing these best practices makes each client’s portfolio unique, which can complicate investment professionals’ ability to scale their respective businesses. Many advisers are therefore unwilling to adopt them.

Further, a philosophical dislike for yielding to other professionals’ recommendations may also limit the use of these practices. However, client dissatisfaction with the status quo and growing challenges in investment markets may soon motivate advisers to embrace change.

Tax-aware advisory best practices require thoughtfully making the most of the after-tax return potential available to each investor. Portfolio management best practices involve an ongoing emphasis on both tax-aware best practices along with implementation of a long-term, buy-and-hold program designed around the client’s objectives. The goal of investment management for high-net-worth investors should always be to maximize each client’s after-tax return in a cost-effective, transparent way. A core-satellite approach and the use of separately managed accounts, along with knowledge of each client’s unique situation, are of absolute importance if the client’s objectives are to be achieved.

Conventional asset managers focus on pretax returns, often viewing the financial adviser as the customer—rather than the actual client. Most asset managers are unaware of and do not consider the best interests of their clients on an after-tax basis. Additionally, asset managers’ costs are substantial regardless of market return. A 2013 Financial Analysts Journal article “Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance” indicated that “all-in” cost for active mutual fund management runs about 2%. Separately managed accounts (SMAs) are typically about half the cost of actively managed funds (or 1%) but have higher minimum investment requirements than mutual funds and are not commonly used by investment advisers.

In our earlier article, we introduced a hypothetical couple around 10 years from retirement—which we refer to here as H and W. The strategies presented here are designed to address a specific case and should not be considered recommendations of any kind. Best practices will vary by the client’s tolerance for risk, stage of life, and other circumstances.

With a sizable portfolio (nearly $1.7 million) and a focus on conservative growth (60% allocation to stocks overall), the couple use two SMAs. The larger core equity SMA account (30% of assets) is in a taxable account and consists of high-quality, actively managed, yet low turnover, large cap stocks.

The second SMA account (about 15% of assets) is tax-deferred and invested in stocks with above-average dividend yields and an objective of dividend growth. By using a deferral account, the couple maximize growth through avoiding the taxation of income from dividends and realized capital gains. The balance of the portfolio is held in a dedicated, tax appropriate, series of mutual funds, exchange-traded funds, and money market accounts.

Assigning assets a specific account location based upon their tax implications can provide significant  value for clients. And once a workable location management plan has been achieved, the important execution elements can then be introduced. Executing a unique, after-tax plan designed around each client’s specific objectives and constraints completes the value-add proposition.

Maintaining a gain budget

Establishing and adhering to a well-designed gain budget can provide both tax and investment advisory professionals with a blueprint of acceptable net realized gains to be taken over the course of a year. A well-defined understanding of the budgeted realized gains can go a long way toward avoiding unexpected or onerous tax bills and unpleasant year-end surprises. A well-designed gain budget will result in a  more predictable tax outcome, as well as demonstrate to the client that the tax professional is involved to a greater degree when necessary during difficult, volatile investment markets.    

Creating an annual gain budget should be a part of every successful client advisory program. Advisory best practices should:

  • Consider taxes in timing transactions (yet taxes alone should not drive decision-making).
  • Trade sparingly with an emphasis on long-term gains (positions held for more than one year).
  • Avoid excessive liquidation of the portfolio (the result of market timing or manager placement).

Our tax professional, after consultation with the couple, has established a realized gain budget for the year of $35,000. Once the realized gain budget has been established, the investment adviser can then manage the assets, including realization of both gains and losses, within a more disciplined, prescribed framework. While the budget is not cast in stone (as there is bound to be slight deviation), it serves an important reference point that will help to ensure that taxes do not unduly affect the couple’s preretirement portfolio growth.

When retirees are ready to begin drawing down their portfolios, avoiding disrupting those withdrawals because of too much tax from excessive gain realization is especially important. Establishing and maintaining a realized gain budget should improve the couple’s after-tax returns and increase the amounts that they can actually spend while avoiding unpleasant tax outcomes.

Tax-loss harvesting

Postponing gain realization with an emphasis on realizing losses, especially short-term losses because they offset gains at higher tax rates, can be a great way to benefit clients through disciplined management of the time value of taxes. This planning technique postpones the realization of unnecessary gains while capturing losses wherever possible so as to limit near-term tax drag. Unless taxes rise significantly, this strategy should offer a significant benefit to clients with taxable portfolios.

Harvesting losses on an ongoing basis, not just late in each year as is typically the case with most asset managers, is a great way to build a reservoir of both short-term and long-term losses. These losses often accumulate during volatile or declining markets, yet they can be used to offset gains in portfolios when and where needed as the rules allow. The strategy requires a focus on positions held for less than one year and the use of highest-in, first-out (HIFO) accounting to postpone or minimize taxes. Supporting the accumulation of a reservoir of losses (as opportunities present themselves) is a great way for tax and investment professionals to benefit their clients during market corrections when few other opportunities may exist.

By avoiding wash sales through disciplined planning and execution, maintaining accurate tax-lot accounting, immediately reinvesting in similar securities to avoid portfolio tracking problems, and not purchasing identical funds (which would trigger the wash-sale rule), realized losses can be safely generated to offset realized gains taken elsewhere in the portfolio.

Tax and investment advisory professionals have determined that H and W should maximize tax-loss harvesting opportunities throughout the year and the couple have agreed. To that end, the securities within the larger core taxable SMA (over $500,000 in value) will be reviewed at least quarterly or when conditions warrant to determine if tax-loss harvesting opportunities exist. While clearly dependent on how the market performs, with an ongoing, methodical process, the after-tax benefits of loss harvesting could be significant for H and W. In a market where investment returns fall below expectations and income is more difficult to sustain, tax-loss harvesting can be a great way to add after-tax value for clients.

Maintaining a long-term focus with a buy-and-hold portfolio

Buy-and-hold portfolios, especially those run by firms focused upon high-net-worth investors, can avoid many of the common pitfalls associated with conventional asset management including:

  • Reducing portfolio turnover.
  • Limiting long-term gain realization.
  • Minimizing short-term capital gain realization.
  • Avoiding market timing.

By concentrating on supporting the best possible after-tax return through a buy-and-hold portfolio, tax and advisory professionals can create substantial benefit for their clients. In a recent study by Yahoo Finance, investors who missed only 20 of the best days over a 20-year time frame sliced their annual returns by an astounding 67%. Imagine what effect this would have on asset growth.

The holding period, another important discipline associated with buy-and-hold portfolios, is often woefully short term with conventional asset managers. According to The Age of Stagnation (a recently published book on impending economic stagnation by Satyajit Das, Prometheus Books) the average stock holding period has declined from around seven years in the 1940s to seven months today. Further, high-frequency trading algorithms (accounting for as much as 70% of daily stock trading volume) have an average holding period of only 10 seconds!

H and W have agreed to embrace a long-term buy-and-hold portfolio. With less turnover and fewer transactions, the couple’s realization of gains, especially short-term gains, can be substantially diminished. Further, with a long-term focus, distractions from market volatility and the associated market timing transgressions can be controlled or eliminated.

With over 30 years each of portfolio management experience and analysis, we are convinced that high-net-worth portfolio managers should make only modest—absolutely necessary—alterations to portfolios, ranging from a conservative posture to a moderate risk exposure (early in the growth phase of the cycle). And this restraint becomes even more important with taxable investments.

Behavioral coaching

Investor behavior often damages returns. The most recent Dalbar study of high-net-worth investors’ equity returns indicates that investors captured only 3.66% of the 10.35% annual gain possible in the stock market over the 30 years ending in 2015 (Dalbar press release, “Better Investment Recommendations Equal Greater Returns” (4/26/16)). This is a powerful example of how damaging market timing can be. Other reasons for suboptimal market performance among investors may include that the fund manager who actively manages the fund often underperforms and charges significant fees. Equally unsettling, individual investor respondents to a recent Legg Mason Survey indicated that they would, on average, capitulate (or sell) after a market decline of 22%—meaning they would quit at (or near) the worst possible time!

It is vital that both the tax and investment advisory professionals convey a consistent, reassuring message that is judicious and direct, and assures eventual recovery as it will help clients stay the course with their investments. This may be the most critical role tax and investment professionals can play.

As we noted in our first Tax Insider article, a 2014 Vanguard study showed that tax and investment advisory professionals can add up to 3% to each client’s annual return (see Kinniry, et al., “Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha” (Vanguard, March 2014)).

Morningstar calls this benefit “Gamma,” as we also described in our Tax Insider article (see Blanchett and Kaplan, “Alpha, Beta, and Now . . . Gamma” (Morningstar Investment Management, Aug. 28, 2013)).

Quantifying the various benefits attributable to the execution of the best practices described here is difficult and will vary by each client’s family circumstances and stage of life. However, as the Dalbar and Legg Mason studies clearly demonstrate, behavioral coaching can add significant value and help to avoid the damage associated with quitting at the worst time.

Improved client outcomes should always be the focus of trusted advisers, yet investment and tax professionals can lose sight of this objective. Clearly, the tax professional’s role in supporting the best possible solution cannot be overstated. Instituting best practices requires dedicated planning and execution by committed professionals. Without the assistance of an engaged and committed tax professional, the benefits of tax-aware advisory, portfolio management, and behavioral coaching are unlikely to be achieved.

Steve Riley, CFA, CFP, and Rick Furmanski, CFA, CFP, are portfolio managers at Clearview Wealth Solutions in Lake Zurich, Ill.

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