Something that always confounded me is how wealth managers generally don’t think in terms of “effective value” for their accounts. They restrict their thinking to the reported dollar value of the accounts they’re managing, not taking taxes or fees into consideration. These before-tax and before-fee numbers are deceptive–comparing taxable values against non-taxable values is like comparing apples and oranges.

William Reichenstein, CFA wrote an article in Investment News that illustrates the problem:

I want to make a case for calculating asset allocations in retirement accounts on an after-tax basis. First, consider 55-year-old Peggy, who is single and believes that she will be in the 25% marginal tax rate in retirement.

She has $7,500 in a Roth individual retirement account and $10,000 in a 401(k), and both are invested in the same stock fund, whose value we’ll assume will double before withdrawal in retirement.

At that time, based on our assumptions, the Roth IRA will be worth $15,000 after taxes, permitting Peggy to withdraw the funds and buy $15,000 of goods and services.

Her 401(k) will be worth $20,000 before taxes at withdrawal, or $15,000 after taxes, also permitting her to buy $15,000 of goods and services.

Whether the underlying investment earns 100% or 300%, or loses 20%, these accounts will buy the same amount of goods and services in retirement. Therefore, they should be considered equivalent today.

Generalizing, each $1 of pretax funds in a tax-deferred account will buy the same amount of goods and services as (1-T) dollar of after-tax funds in a tax-exempt account, where T is the marginal tax rate in retirement.

Conceptually, it is useful to separate each pretax dollar in a tax-deferred account into two components: a (1-T) dollar of the individual’s after-tax funds plus a T dollar, which is the government’s share of the current principal.

Therefore, the $10,000 in Peggy’s 401(k) is like $7,500 of her after-tax funds plus $2,500, which is the government’s share of the current principal.

The government effectively owns 25% of the current principal because it is like a silent partner that will get 25% of all withdrawals.

This problem is pervasive throughout every element of portfolio management systems. Returns should be tax-sensitive, as should gains and every other calculation on your reports. And it goes further than taxes. Your PMS should be aware of back-end loads on funds, trading commissions, and any other expense that will be incurred when the client liquidates. If you tell your client his account is worth X, it better not be worth 80% of X.

Pretty simple concept, right? The article is just talks about retirement accounts, but the “effective buying power” concept would ideally be applied to *all* types of accounts. Speaking as somebody who has built a few portfolio management systems, this is almost impossible to implement. The tax laws are just too complicated, and the problem affects too many parts of the software.

One area this would be extremely helpful is with separate accounts. Say you are managing a traditional buy-and-hold account for a client and an outsourced, often-traded separate account. Your separate account probably has more realized gain than the buy-and-hold account, and the client has already paid taxes on it.

When you send your quarterly reports, you show each account to be worth $500k. But in terms of “effective value”, the buy-and-hold account is worth much less because taxes are still owed on all the gains. Whereas with the separate account, the client has already paid much of the gain tax already and the $500k number is much closer to the account’s actual value.

But your client doesn’t know that. Just looking at your top-page portfolio summary report, he sees only that he invested $250k in each account and they’re now worth $500k. Even his returns reflect a tax-free gain. Unless he looks at (and you provide) an unrealized gain report, he won’t have a inkling that the separate accounts are actually worth more than the others.

The article concludes:

I believe that using an after-tax approach to asset allocation in retirement accounts is a better way for advisers to add value. It distinguishes between pretax funds and after-tax funds, recognizing that taxes exist and that taxes have a very big effect on buying power.

By contrast, the traditional approach fails to distinguish between pretax and after-tax funds, and as a result can lead to a distorted idea of retirement purchasing power.

Of course, in calculating Peggy’s after-tax asset allocation, we must estimate her retirement tax rate, which, in practice, is unknown. But even if we estimate that tax rate, it’s still better to calculate an after-tax asset allocation than ignoring taxes completely.

By failing to distinguish between pretax and after-tax funds, the traditional way of calculating asset allocations in retirement accounts implicitly assumes a zero tax bracket in retirement. That of course is a delightful fantasy.

To repeat, calculating an after-tax asset allocation requires that the adviser convert the market values of all assets to their after-tax values and then calculate the asset allocation using these after-tax values.

…Doing this reflects the reality that taxes exist and enables advisers to give clients an apples-to-apples comparison of the funds in all their retirement accounts

Interesting concept. I don’t think we’ll ever see it, but its always helpful to understand the right way and wrong way of doing something. That way you know what you’re looking at it if anybody ever figures it out.