INDUSTRIAL ENGINEERING APPLICATIONS IN FINANCIAL ASSET MANAGEMENT:TAXATION

TAXATION

Taxes are largely immaterial for pension funds, foundations, endowments, and offshore investors because of their exempt status. Mean-variance asset allocation can be applied directly for these investors as already described. However, for domestic investors, taxes are a critical issue that must be considered in modeling investment choices.

Tax-Efficient Optimization

Interest, dividends, and short-term capital gains are taxed at ‘‘ordinary’’ income rates in the United States. The combined federal, state, and local marginal tax rate on such income approaches 50% in some jurisdictions. In contrast, long-term capital gains are taxed at a maximum of 20%, which can be postponed until realization upon sale. For this reason, equities are tax advantaged compared with bonds and investments that deliver ordinary income.

In an unadulterated world, MV analysis would simply be applied to after-tax return, risk, and correlations to produce tax-efficient portfolios. Regrettably, tax law is complex and there are a variety of alternative tax structures for holding financial assets. In addition, there are tax-free versions of some instruments such as municipal bonds. Further complicating the analysis is the fact that one must know the split between ordinary income and long-term gains to forecast MV model inputs. This muddles what would otherwise be a fairly straightforward portfolio-allocation problem and requires that tax structure subtleties be built into the MV framework to perform tax-efficient portfolio optimization.

Alternative Tax Structures

As one might imagine, modeling the features of the tax system is not a trivial exercise. Each structure available to investors possesses its own unique advantages and disadvantages. For example, one can obtain equity exposure in a number of ways. Stocks can be purchased outright and held. Such a ‘‘buy-and-hold’’ strategy has the advantage that gains may be realized at the investor’s discretion and the lower capital gains rate applied.

Alternatively, investors may obtain equity exposure by purchasing mutual funds. Mutual fund managers tend to trade their portfolios aggressively, realizing substantially more short-term and long- term gains than may be tax efficient. These gains are distributed annually, forcing investors to pay taxes at higher rates and sacrificing some of the benefits of tax deferral. If portfolio trading produces higher returns than a simple buy-and-hold strategy, such turnover may be justified. But this is not necessarily the case.

A third option for equity exposure is to purchase stocks via retirement fund structures using pretax contributions. Tax vehicles such as 401k, IRA, Keogh, and deferred compensation programs fall in this category. The major benefit of this approach is that it allows a larger initial investment to compound. However, upon withdrawal, returns are taxed at ordinary income tax rates.

A fourth alternative for achieving equity exposure is through annuity contracts offered by insur- ance companies. These are often referred to as wrappers. This structure allows investors to purchase equity mutual funds with after-tax dollars and pay no taxes until distribution. Thus, gains are shel- tered. Even so, all income above basis is taxed at ordinary rates upon distribution. Investors receive deferral benefits but lose the advantage of paying lower rates on returns arising from long-term capital gains.

Although I have described four alternative tax vehicles for equity exposure, the same general conclusions apply for other assets. The one difference is that consideration of ordinary vs. capital gains differentials must explicitly be considered for each type of asset. Table 5 summarizes the tax treatment of investment income through currently available tax structures.

Results of Tax-Efficient MV Optimizations

Another perplexing feature of the tax system is that after-tax returns are affected by the length of the holding period. For example, it is well known that the advantage of owning equities directly increases the longer is the holding period. This is because deferring capital gains produces benefits via tax-free compounding (Figure 7). Similarly, assets in insurance wrappers must be held over very long periods before the positive effects of tax-free compounding offset the potential negatives of converting long-term gains to ordinary tax rates.

When it comes to applying the MV approach to taxable investing, the methodology is the same as that used for tax-free portfolios, except that four different after-tax return streams, risk measures, and four-square correlations are required for each asset. Table 6 compares the pre-tax and after-tax returns for assets typically considered in taxable portfolio allocation studies.

A complete review of after-tax-efficient frontiers would be beyond the scope of this chapter. However, there are four general conclusions. First, a basic conclusion of most after-tax allocation studies is that investors are well advised to hold the maximum possible portion of their investable wealth in tax-deferred vehicles such as 401k programs and deferred compensation plans. The 401k structure is particularly attractive because employers often match employee contributions.

Second, after maximizing contributions to tax-deferred vehicles, investors should utilize buy-and- hold strategies for equities and hold municipal bonds as the appropriate fixed income investment. Third, hedge funds enter most optimal allocations directly even though as much as 75% of the income is taxed at ordinary rates. Optimal allocations to hedge funds are lower than for tax-exempt investors, however. Fourth, for long horizons of at least a decade and more, wrapped assets often enter optimum portfolios, particularly for hedge funds.

Ordinary tax rates are assumed to be 46% (state and federal). Incremental costs of 1% annually are deducted for the wrap structure.

These generalizations presume investors are in the top marginal tax bracket (federal, state, and local) both at the beginning of the horizon and at the end. The extent to which investors move into lower brackets via diminished post-retirement income or by migrating to lower tax jurisdictions make the benefits of deferral even greater.