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May 19, 2011 at 03:46 PM
A presentation by David Lau at the National Association of Personal Financial Planners annual conference in Salt Lake City on Thursday sought to explain the so-called tax efficient frontier, and advocate for maximizing its potential in client portfolios. Lau, chief operating officer with Jefferson National Life Insurance Co., said advisors can improve the tax efficient frontier through “the power of tax deferral.”
The concept, based on the notion of the efficient frontier (first defined by Dr. Harry Markowitz in 1952 in relation to modern portfolio theory), seeks to achieve optimal portfolio returns within a universe of risky investments.
“Tax deferral is an important part of wealth accumulation and portfolio optimization, not just from a risk/return standpoint, but from the standpoint of what’s left after the government taxes the investment gains,” Lau says.
Research published in June 2010 by the University of Chicago and Jefferson National found that tax deferral can potentially increase returns by as much as 100 basis points without increasing risk.
Why is something like that important, especially now, he asks? Most people think taxes will rise. When they will rise and by how much is still open to debate, but the Bush-era tax cuts will sunset at some point and it will affect every tax bracket.
“The tax efficient frontier seeks to identify those asset classes that can harness the power of tax deferral without raising risk,” Lau added. “It is a simple formula, one that holds tax efficiency equals after-tax total return divided by the pre-tax total return. What we’ve found is that tax deferral works especially well in increasing bond returns. Taxable bond funds gain 120 basis points in excess yield when placed within a tax-deferred wrapper.”
However, he noted the efficiencies of tax deferral take longer to reach with equity funds because equities are already tax efficient. From his analysis, it typically takes 22 years to reach the breakeven points for equity funds in a tax-deferred environment. As a result, he believes equity index funds work especially well in a taxable environment.
“The solution is a low cost, no load variable annuity with a wide array of sub-account investment options,” Lau (left) said. “The advisor would be wise to put the equity portion in taxable accounts. For the tax inefficient, fixed income portion a low cost variable annuity makes sense for those who have maxed out their qualified accounts.”