Independent Thinking®
It Matters What You Keep
January 20, 2015
Everyone knows the saying that it’s not what you make that matters, it’s what you keep. In this increasingly high-tax environment, private investors need their assets to generate the best possible risk-adjusted real returns.
Many investors underestimate the impact of taxes on private accounts, however. Asset allocation construction, modeling, and optimization analytics are generally based on pre-tax return expectations. The reason, apart from a general institutional client bias in the investment industry, is the distance in many large financial services firms between the portfolio manager and the actual client. Indeed, there can be as many as three or four organization levels involved in translating the client’s goals and constraints into an investment portfolio.
Like the children’s game of telephone, it’s easy to see how the original message is lost. At the far end of the line, portfolio managers may quibble over pennies in transaction costs while realizing a short-term gain that makes sense for a non-taxable institutional investor, but incurs a top marginal federal and state income tax rate close to or exceeding 50% for a New York or California resident.
It seems to us that investors are best served by an approach of radical transparency; one that is rooted in direct relationships and integrates investment management and financial planning. Clients who work directly with a wealth advisor and a portfolio manager, both of whom are aware of their tax situation, can expect better designed and managed portfolios than most private investors.
At Evercore Wealth Management, we consider after-tax return assumptions in implementing our investment strategies on behalf of clients through our Efficient Architecture® platform and in our approach to wealth planning. As the direct manager of our clients’ core equity and municipal bond portfolios, we are able to control the timing, quantity and rate (long-term vs. short-term) of transactions as appropriate, given the tax liability. Asset location is also critical in how we invest tax efficiently on behalf of our clients; we locate our credit and diversified market strategies in tax-deferred accounts whenever possible.
We are also mindful of tax when allocating to any of our carefully selected and monitored external advisors, focusing on managers who record both low turnover and a low tax drag on their returns, and avoiding strategies in which the diversification benefits only make sense in pretax terms. (A recent Aperio survey suggests that over three quarters of the total capital appreciation from actively managed funds is distributed as taxable income to investors.) We often use index or even passive tax loss harvesting strategies, through which losses can be applied to tax-inefficient asset classes, thereby improving the after-tax return of the entire portfolio.
From a planning and charitable giving standpoint, we encourage clients to use highly appreciated stock in lieu of cash for donations and to incorporate this gifting throughout the year as part of a portfolio rebalancing exercise. Rather than sell appreciated assets to rebalance, we encourage clients to gift the appreciated assets and use cash for rebalancing.
Another way that we think about taxes in the context of integrated investment and wealth planning is in the use of grantor trusts. Many families may have established grantor trusts for their children and grandchildren in which the grantor is responsible for paying the income taxes on behalf of the trust (see Julie Krieger’s article on page 14). These trusts often have provisions that allow the grantor to substitute assets of an equivalent value, which can afford planners the flexibility to revise asset allocations across different family entities. A grantor could substitute, say, $1 million of cash for $1 million of a highly appreciated stock that has a cost basis of just $200,000.
By gaining a comprehensive understanding of our clients’ financial affairs, we can typically identify opportunities to minimize realized gains while making prudent long-term asset allocation decisions. For example, grantors who wish to increase their equity allocation at the same time that assets are being rebalanced within their trusts could structure the transactions to employ an asset substitution that won’t incur a capital gains tax. This approach can transfer the appreciated equity securities back to the grantor and place cash or other higher-basis assets in the family trusts.
Additionally, the grantors may then immediately diversify by giving the low-basis stock to a private foundation or charitable remainder trust. If they are older, they might stay with the low-cost position until death, when the holding will receive a step-up in basis.
Managing tax-efficient personal portfolios isn’t easy, in large part because this is not the lens through which the financial services industry tends to view investment or planning. The complexity of our federal and state tax laws also discourages many professional investors from this approach, because it is hard work to deal with each client individually and make recommendations based on each specific tax situation. Will Rogers observed almost 100 years ago that, while the only certainties in life are death and taxes, at least death doesn’t change every time Congress meets.
Still, it’s our job as fiduciaries to keep pace with every change to the tax code and to understand its implications for each of our clients and their families. Tax efficiency is more than a factor in great wealth management; it’s how we approach the management of each client’s assets.
Iain Silverthorne is a Partner at the Evercore Wealth Management office in San Francisco. He can be contacted at [email protected].