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Eric Nelson: Save Your Portfolio From Taxes, Low Interest Rates

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Outspoken financial advisor and investment thought leader Eric Nelson, 39, is fired up about what he calls today’s “new world” for retirement planning, wherein he is turning traditional asset allocation on its head. With bonds at a dismal 2% and 3%, the RIA argues that portfolios should hold at least 60% in stocks as the only realistic way to reach retirement income goals, he told ThinkAdvisor in an interview.

The candid blogger and CEO of Servo Wealth Management in Oklahoma City, Oklahoma, made waves in early 2014 reporting that his portfolio of Dimensional Fund Advisors funds – using an asset-class investing approach – was superior in performance to the returns of Warren Buffett, Jeremy Grantham and John Bogle over the decade through February 2014, which of course included that grim year, 2008.

Nelson’s research used performance results of those top managers to represent active management, tactical management and indexing versus his asset-class approach.

One notable advantage of Nelson’s tack is that it offers greater tax efficiency than many other approaches, Nelson says. Smart tax investing is necessary to reach client goals of highest after-tax returns. Nelson, a native of Syracuse, New York, who uses no exchange-traded funds, stresses that mutual funds are sometimes more tax-efficient than ETFs, which are widely touted for their tax efficiency.

ThinkAdvisor recently chatted with the opinion leader, who manages $55 million for 30 high-net-worth clients. Before launching his RIA, he was an FA with PaineWebber and Charles Schwab, among other firms. Here are highlights of our conversation, which featured a few 2015 tax-bill surprises and a how-to on asset-class investing:

What’s hot on your mind?

It’s a whole new world for retirement planning: Retirees need to become more comfortable with a little more short-term volatility in their portfolios that comes from holding more stocks. This is a scary proposition for someone who looks at security as the short-term value of their portfolio. But in reality, security is a portfolio with the best chance of earning a return over time that outstrips the amount of spending you need from it.

What do you suggest for the stock allocation, then?

No one with reasonable retirement goals can afford to have less than 60% in stocks, and some, who want to leave a legacy to their loved ones, might want to be as much as 70% or 80% in stocks. We’re all living longer, so you need to ensure that you’ve done everything to maintain the purchasing power of your income over two or three decades.

But where do bonds fit in?

You can’t afford to have too much in bonds that pay 2% or 3% and expect to eventually not dip into and deplete your principal while trying to maintain a growing stream of income.

What’s your specific recommendation for bonds?

To have just enough parked in that asset class so that if the stock market goes down for a couple of years, you can sell those bonds to meet your yearly income goals and then revert to selling stocks only after the market has recovered. About two to five years of income in bonds and the rest in a diversified stock portfolio is the only way you can give yourself a high probability of earning enough so that the growth in your portfolio outstrips the growth in your spending. Do you always discuss the tax implications of an investment that you recommend to a client?

Absolutely.  It doesn’t do any good to make an 8% return if you pay half of it back in taxes. Tax management and smart tax investing has to be done on a customized basis, though, because everyone has different account structures depending on, say, life stage; or if someone has all their money in a taxable account, they might require a different strategy than a client that has 50% of their money in an IRA.

What should be one’s mindset about investing and income taxes?

You want to make as much money as you can for the risk you’re taking — and one easy way to do that is to pay less in taxes. At the same time, you can’t focus only on taxes. So the goal is the highest after-tax return — not to pay the least amount of taxes.

Will there be any surprises for folks when they get their tax bills for 2015?

I think so. What always surprises people who hold mutual funds is when these funds distribute a lot of capital gains after a year in which they haven’t made any money: investors get stuck with a tax bill without a gain. Last year, mutual funds wound up selling longtime positions that made them a lot of money over the years and distributed it at a capital gain of 5%, 10% or even 15% or 20% of the value of the portfolio.

Clients might be thinking, “Gee, I didn’t make any money last year because stocks didn’t go up — but at least I won’t have to pay taxes.”

They could be wrong. If the mutual funds distributed a capital gain, investors wind up paying taxes without a commensurate gain to show for it: They didn’t get the benefit of those stocks that were sold for big gains over the last couple of years. Last year they got negative returns – but they got the tax bill that went along with the good returns because the stocks that did really well over the years were sold.  

How effective are variable annuities to minimize taxes?

The whole notion of a variable annuity helping you with taxes is nonsense. But people hear “tax deferral” [and go for it]. It’s being sold very well to them, and for good reason: agents and brokers make 7% or 8% commission on those things. A variable annuity is only a tax-deferred vehicle when you take the money out of it and pay income taxes on all the money, whereas, if you invested those same taxable dollars in, say, a Vanguard S&P 500 fund, you pay a little bit of taxes every year on the dividends. Then, when you sell, you pay long-term capital gains taxes. Therefore, it’s much more tax efficient long term.

I gather you don’t much care for VAs in general!

Variable annuities are almost universally horrible. I can say this as someone who sold them on commission back in my dark days. They’re designed to be sold, not bought. They pay agents and brokers very high commissions. So because the payouts are so large, they’re incentivized to sell annuities to people who really don’t need them. Moreover, insurance companies have ginned up these things with pseudo-guarantees, saying buyers aren’t going to lose money or that they’re able to pass on the original principal value to their heirs even if it’s dipped below that in a bear market. Strong selling point.

Yes. People feel they’re getting some sort of free lunch: stock returns with no risk. In reality, they’re paying a very high fee for that – and, you can do basically the same thing outside a variable annuity.

What about clients who were invested in master limited partnerships last year? If the MLP undergoes debt restructure, it may be surprising for unit partners to get a tax bill for income not received.

MLPs are a tax nightmare. There’ a lot of creative accounting. But MLPs got crushed recently, and the tax problem is the least of their worries. MLPs are terrible investments. They’re basically a reach for yield and secondly, [nearly] all MLPs are in the oil and gas industry.

You specialize in asset-class investing. Is that a good strategy to reduce taxes?

It’s a more predictable, stable approach than forecasting what’s going to happen next in the market — and it’s also more tax efficient.

What exactly is this investing approach?

The philosophy is to hold the asset classes that have higher-than-market returns: large and small value stocks; in bonds we want to be safe and keep them short-term and high-quality. We want to own the haystack and not the needle: We’re broadly diversified and want to buy the entire category or all the stocks [mutual funds] and bonds [mutual funds] in a particular asset class.

What do you look for in stocks, specifically?

We focus on asset classes that have produced the highest long-term returns in the market. So my portfolio might start with the S&P 500, but it will include a fund that, say, buys just the largest low-priced value stocks and one that buys just the smallest low-priced value stocks. Historically, the returns to large and small value stocks have been 2% to 3% a year more than the overall market. Most importantly, large and small in growth and value stocks tend to go up and down at different periods of time.

Just what do you look for in bonds?

The primary asset classes are short-term bonds and corporate bonds. Through my asset-class lens, I look at bonds as the safe part of a portfolio designed to stamp out some of the short-term volatility in stocks. It gives retirees something to sell when stocks are down so they can get through to the next two years when stocks have come back. This is a more predictable, stable approach than having to forecast what’s going to happen next, and it’s also more tax-efficient in several ways.

How is it more tax-efficient?

For mutual funds that own stocks in an investor’s taxable accounts, we use tax-managed funds from Dimensional Fund Advisors, whose managers try to avoid passing capital gains taxes through to the investor. For example, they’ll look at tax-loss harvesting. If any capital gains are passed through, they try to ensure that they’re long-term, not short-term because long-term gains are taxed at only 15%, whereas short-term gains are taxed at ordinary income tax rates.

How does a “carry-forward loss” help to minimize taxes?

It’s part of tax-loss harvesting and applies to any type of investment. If I sell something that’s below the value I originally paid and that creates a capital loss, I can use the loss either this year to offset a gain in something else that I’ve sold this year or carry that loss forward and use it next year, or every year until the gain runs out. What about taxes on bonds in your asset-class approach?

Bonds are far less tax efficient than stocks because the interest is taxed at ordinary income rates. But you can control the tax to some extent with asset location – locating tax-inefficient bond investments in clients’ IRA accounts and locating tax-efficient stock investments in taxable accounts.

Any other tax strategies in your approach?

When investments are down temporarily in taxable portfolios, we can sell those mutual funds and recognize the losses, move the money to something similar for 30 days and then turn that paper loss into a permanent loss by selling. This can be used to offset future capital gains.

Do you ever use ETFs for tax efficiency?

No, because managed mutual funds are just as tax efficient, in some cases, more so, especially when you use tax-loss harvesting. Research shows that over the last 15 or 20 years, indexes that underlie ETFs — that I’d want to use — have underperformed DFA mutual funds by 1% to 1.5% a year. Over time, that’s huge. If, for example, I want to own a small-cap fund, an ETF doesn’t own the smallest stocks – so they cost some return. And value stock ETFs don’t hold a higher concentration of the lowest priced value stocks. Also, they tend to hold watered-down growth stocks.

Do you figure that the market has finally bottomed out?

I think we’ve gone through our correction from falling oil prices and profits that have slipped a bit. We’ve done what we needed to do; and eventually, a lot of what’s negative is going to turn into a positive. The stock market is going to be higher in six to 12 months.

Some strategists say that when the U.S. reaches full employment, the market will favor stock pickers over asset allocators. Your thoughts?

That’s nonsense. A stock picker’s market is mathematically impossible. A “good environment for stock pickers” has never been true. It can’t be because stock pickers are professional investors who buy all the stocks on the market. If a certain set of people are buying just the right stocks, who’s owning the rest of them?

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