I’ve been working with financial advisors a lot recently on how to implement better after-tax, after-advisory fee strategies for the bond portion of their portfolios for clients who are in high marginal tax brackets (doctors, lawyers, business-owners, etc).
In a higher bond yield environment, the typical retirement strategy for such clients was merely to increase the allocation of the clients’ portfolio to bonds in order to provide better diversification, fixed income, and protection from sequence-of-return risk. However, in a low-yield environment like the one we are in today, bonds offer low-yields, high tax-liabilities, and subject the client to interest rate risk in the future when interest rates rise.
In other words, bonds pose more risk than benefits for HNW clients nearing retirement!
Here’s a quick math example to illustrate the point.
Let’s say you have a HNW client nearing retirement. You choose to allocate 40% of the client’s portfolio to a short-term bond fund like the AGG in order to avoid interest rate risk. Let’s assume the current pre-tax yield on the AGG is 2% (in reality it’s significantly lower than this). Let’s also assume the client lives in a high state-income tax state like California such that their marginal tax-rate is 50%. Let’s also assume your AUM fee is 1%.
What is the client actually making on an after-tax, after-advisory fee basis?
Well, on a 2% gross yield, they’ll lose 50% to taxes. So now they’re down to 1%. If they then pay your 1% AUM fee using after-tax money, now they’re down to 0%. And if interest rates rise in the future they’ll lose part of their principal too!
Allocating 40% or more of clients’ portfolios to this type of scenario and charging a 1% AUM fee where the client walks away with nothing (and risk for losses in the future) is not a great model for the client.
Below are 6 financial planning strategies that financial advisors can implement to provide better after-tax, after-advisory fee returns for the bond portion of their clients’ portfolios in today’s low-yield environment.
1. Utilize asset location in your investment planning
Asset location merely means putting your clients’ stock and bond investments into the structure that minimizes their tax-liability. This means putting their stock investments into taxable accounts and their bond investments into retirement accounts.
The reason for this is that if you invest in stocks in a taxable account, you already get tax-deferral on the appreciation (no taxes are due on the appreciation until you sell the stock) and you pay a lower long-term capital gains tax-rate on the gains. However, if you invest in stocks within your retirement accounts, while you still get the tax-deferral, you will most likely pay a higher ordinary income tax-rate when you take the gains out.
Bond funds typically distribute most of their gains each year—which means they are subject to ordinary income taxes. If your clients are working professional subject to high tax-rates, they’re making very little on these bonds on an after-tax, after-advisory fee basis. By placing bonds in their retirement account, clients get to defer these gains until they are in retirement and will typically be in a lower marginal tax bracket.
An added benefit to investing clients’ money in retirement accounts is that you as the financial advisor can charge your AUM fee pre-tax (which reduces client’s tax liabilities and increases their after-tax return).
2. Defer taxes on bond gains until your clients are in retirement.
As we mentioned earlier, you want to try and get the majority of your clients’ bond investments into retirement accounts so that your clients can defer the gains on those investments until they are in retirement—when they will be in a lower tax-bracket. They can then withdraw these gains prior to them taking required minimum distributions (RMDs) or receiving social security so these gains will be taxed at lower rates.
The problem is that many high-earning professionals are limited in their ability to contribute to tax-deferred vehicles because of their high income. Some strategies that high-earning professionals can use to bypass this include: SEP IRAs and Solo 401ks individually or combined with Roth IRA conversions, no-commission annuities, guaranteed lifetime income, and indexed-universal life insurance.
3. No-Commission Annuities: Investing in Long-Term Bonds without Interest Rate Risk
Most financial advisors don’t realize that annuities are merely investments in long-term bonds without interest rate risk that allow clients the ability to defer gains until retirement. By ripping out the commissions from these products, clients and their advisors can get significantly better after-tax, after-advisory fee bond returns—all while allowing advisors the ability to charge his or her fee on a pre-tax basis.
Instead of investing in lower-yielding short term bonds subject to high taxes and interest rate risk, clients and advisor get a significantly better after-tax, after-advisory fee solution.
To learn more, read our white paper: Investing in Long-Term Bonds without Interest Rate Risk: The No-Commission Annuity Solution to Improving After-Tax, After-Advisory Fee Bond Returns.
4. Guaranteed lifetime income
Insurance companies offer clients the ability to obtain guaranteed lifetime income for as long as the client is alive. This guaranteed lifetime income is backed by investment grade long-term bond investments that the insurance company makes. However, the yields provided by guaranteed lifetime income are significantly higher than the underlying long-term bond yields. The reason for this is that the insurance company is expecting some of the clients to die early and others to cancel the policy early.
What this means is that if your client is in good health and intends to keep the policy as a financial planning tool, they can achieve significantly higher yields in retirement than investing in those long-term bonds directly!
5. Utilizing uncorrelated assets like life settlements
Uncorrelated assets can provide better portfolio diversification than bonds—particularly in a low bond yield environment. The reason for this is that the underlying cashflows of an uncorrelated asset are not dependent on market, interest, or credit rate risk. So regardless of whether the stock market, interest rates, or credit spreads go up or down, the underlying cash flows of uncorrelated assets are unaffected.
One such uncorrelated asset is known as life settlements. To learn more about this asset class, read our white paper: Investing in Life Settlements: Utilizing Specialized Expertise to Provide Investors Access to Exclusive Uncorrelated Returns.
6. Utilizing Private Placement Life Insurance or No-Commission Life Insurance to Provide Higher After-Tax, After-Advisory Fee Retirement Income
One of the benefits of life insurance is that clients can invest in assets and then remove 90% or more of the principal and gains in the asset tax-free. The problem with most life insurance products, however, is that the large commissions and expenses in the products negate the tax-benefits.
Private placement life insurance rips out most of these commissions and expenses and allows RIAs the ability to craft their own alternative investment strategies and make those investment returns tax-free for their clients—all while charging their AUM fee on the assets.
No-commission life insurance offers similar benefits—but without the ability for the RIA to craft its own alternative investment strategies.
To learn more about the benefits of using private placement life insurance to create tax-free retirement income, read our white paper: Increasing After-Tax, After-Advisory Fee Retirement Income for High Net Worth Clients: The private placement life insurance solution many fee-only RIAs and family offices are neglecting.