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Separate Accounts, Taxes, and You

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It seems almost guaranteed that 2002 will not be a memorable year for investment performance. However, performance reporting is another matter. This year has seen sweeping changes from the SEC in regard to after-tax reporting of mutual funds. Not to be outdone, the Association for Investment Management Research (AIMR) is redrafting standards for the red-hot separate accounts industry. This is a significant and much-needed development enabling advisors to better serve their taxable clients. As an advisor, it is important to understand what AIMR is requiring of “separates” managers, how this differs from mutual fund reporting, and what this means to you and your taxable clients.

This spring, the SEC began requiring all mutual funds to disclose after-tax returns in prospectuses and annual reports. Funds must now reveal what an investor, starting with cash, would have received in after-tax returns for one-, five-, and ten-year periods. Pretax returns are adjusted using the top federal rate and then displayed in two ways: returns after taxes on distributions (preliquidation); and returns after taxes on distributions and sales of fund shares (postliquidation).

Preliquidation returns apply to investors who did not redeem shares. In this case, investors hold their shares for the measurement period and pay taxes only on capital gains and dividend distributions. Postliquidation returns assume investors sell their shares at the end of the period and pay capital gains taxes. The SEC requires both returns to offer investors the “big tax picture” for both manager trading and shareholder redemptions.

The newly available mutual fund numbers reveal that the returns and relative rankings of various funds can meaningfully shift when taxes are considered. The new numbers give taxable investors a way to assess a manager’s impact on their true bottom line. This reporting has already proved helpful in identifying those funds that deliver better after-tax performance. Using Morningstar data and comparing the rankings of the two largest stock funds, the Vanguard 500 Index Fund and Fidelity Magellan, we see a clear example. On a prefee, pretax basis, Vanguard ranks 67th out of 121 diversified U.S. stock funds over the last ten years; Magellan ranks 82nd. Using the new SEC numbers for after-tax, after-fee performance, Vanguard vaults to 39th and Magellan moves to 75th.

So far this information is only required in prospectuses and annual reports. As a result, advisors need to do more due diligence or use other sources to find a firm’s after-tax performance.

The Separate Accounts Challenge

AIMR has been providing investment performance guidelines since the late 1980s. “AIMR compliance” has become shorthand for the industry’s highest level of performance reporting, directed toward money managers who administer individual or institutional separate, private, and nonpooled accounts.

AIMR plans to release its guidelines for reporting after-tax performance on separate accounts this fall.

The SEC may have beaten AIMR to the punch in requiring after-tax performance disclosure, but not for lack of foresight. AIMR established a subcommittee on after-tax reporting in 1994. What has made AIMR’s work challenging is that separate accounts are profoundly different investment vehicles requiring a more complex, flexible approach.

The immense popularity of separately managed accounts stems from their ability to be customized to accommodate investors’ tax, risk, and social investing preferences. Over the past five years, separately managed accounts have outpaced mutual funds in growth rates–in large part due to flows from high-net-worth taxable investors. (From 1996-2001, separate accounts grew at a 21% compound annual growth rate to over $400 billion in assets.)

For separate account after-tax reporting, AIMR sees the need for different reporting requirements to better capture the customized moving parts. They allow for customized tax rates, customized investment flows, and the distribution of capital losses. Here are the key differences from the SEC reporting requirements.

1. Custom Tax Rate Recognizing that separate account reporting is for each individual client, AIMR recommends using the client’s expected tax rate–including state and local taxes–which it calls the anticipated tax rate. This is a departure from the SEC requirement that only the highest federal rates be used.

According to AIMR, the anticipated rate should be the tax rate that the manager expects the taxable client to face on returns for that period. This requires interaction between the manager and advisor/client in determining the anticipated rate through the development of investment policy guidelines. The tax rate should be determined at the beginning of the reporting period and should guide the manager in decision-making. This could result in a customized report for the client based on residence in a high-tax state or an AMT status. If the anticipated rates are unknown, which is often the case with wrap accounts, it is permissible to use the maximum federal tax rates.

2. Preliquidation Preferred Mutual funds are required to show preliquidation and post-liquidation returns for an initial cash investment. AIMR requires only preliquidation returns, which measure the rate of change of market value each period after adjusting for the investor’s investment flows. In this preliquidation method, taxes are computed only on transactions that create taxable events. Taxable events include realizing gains or losses and dividend distributions. With preliquidation returns there may well be a future tax liability on unrealized gains. There may also be a tax benefit when there is a net loss position.

The SEC definition of postliquidation returns is meaningful only for investments starting from cash; postliquidation returns for two successive periods cannot be meaningfully linked to get returns for the combined period. A measure of the rate of change of liquidation value each period is useful, but it does not allow one to assess whether the manager is truly talented in building long-term after-tax wealth. For AIMR, post-liquidation reporting is optional.

3. Optional Benchmarks Benchmarks have long been helpful in evaluating the relative pretax performance of a manager. After-tax benchmarks extend that usefulness to the taxable arena and allow advisors to do away with some of the flawed or limited shortcut evaluations for tax efficiency, such as portfolio turnover and capture ratios. With the right benchmarks, advisors can make apples-to-apples comparisons of both pre-tax and after-tax returns.

Unfortunately, at this point, the industry has not converged on standards for after-tax benchmarking. Benchmarks for after-tax reporting need to straddle the fence between flexibility and simplicity, and the difficulty is that the timing of cash flows and the cost basis of the investments produce different after-tax results for investors holding the same securities. It is hard to imagine a precise after-tax benchmark with broad enough application even for portfolios managed in the same fashion. While AIMR has not required the use of after-tax benchmarks, it is encouraging their use and has opened the door to two helpful approaches:

After-Tax Return Indexes This is an intuitive solution–an after-tax version of a standard index. Using capital gain, dividend, and turnover data, one can simulate the after-tax return of a given benchmark such as the Russell 3000. AIMR is hopeful that the more serious index purveyors will start to compute the after-tax returns of investments benchmarked to their indexes from various starting dates.

Shadow Benchmark Portfolios This approach imagines what would have happened had the client invested in a passive vehicle such as an exchange-traded fund or mutual fund indexed to the target benchmark. An investment in a shadow benchmark is simulated for each investor using the actual benchmark’s pretax price returns, dividends and turnover. The benchmark simulation shadows the investor’s actual investment flows and tax rates, and keeps track of the market value, cost basis, and taxes generated by the investment over time. With these, the after-tax performance can be calculated for the benchmark in the same way it is for the portfolio.

Making It Work for You

We have only touched on the highlights of the AIMR requirements. AIMR specifies numerous requirements for the presentation of after-tax composites. Composites of separate accounts could be made up of several portfolios, each with different start dates, cash flows, cost bases, and holdings. The AIMR standards also require the disclosure of many additional items of information important for a more detailed understanding of after-tax performance.

The upcoming guidelines clarify that after January 1, 2004, any firm that claims compliance with the AIMR standards and chooses to present after-tax returns must comply with the revised after-tax provisions and must present after-tax performance that satisfies these minimum requirements.

Some investment managers may fight the need to provide after-tax returns, and they will invent creative reasons not to do so. Argue with them against this, and demand to see after-tax returns. Without them, neither you nor your clients have a good sense of what they are achieving.

The explosive growth of separate accounts and the pace of product development are demanding change. Everywhere you turn you see a new wrap-sponsor program, a multimanager account, or an institutional manager entering the high-net-worth separate account arena claiming tax-efficiency.

With these new standardized after-tax performance measures, advisors to taxable clients can move away from the potentially misleading focus on pretax returns and the tax-exempt models for choosing managers. A manager’s strength in serving institutional clients may not translate into good after-tax performance for HNW investors. Knowing what is required of your managers will help you sort out the truly tax-savvy managers from the pretenders and give you and your clients the best chance of finding the kind of taxable money management talent they deserve.