Investors should hold a mix of stocks and bonds. Most high-income investors have limits on their ability to shelter savings, so they need to invest a significant amount in brokerage accounts. Depending on their risk tolerance, some of these assets will inevitably be in corporate, federal or municipal bonds.
We do a number of analyses where we estimate optimal savings strategies. To do it right, we need to incorporate realistic expenses, including taxes, asset management fees and expense ratios, to come up with a true net return on a portfolio. When we use realistic estimates, net returns on taxable bonds in AUM accounts at today's interest rates are depressing.
How depressing? Let's start with today's 4% rate on Aaa long-term corporates, which is about as high a yield as an investor can expect to receive on bonds (note that junk, or high-yield, bonds are really more equity-like since their historical correlation with stocks is about 0.6). But a 4% return isn't a 4% net return.
As an example, let's place $1,000 in a Aaa bond portfolio that provides coupon payments of $40 through the year. If one's total state and federal marginal tax rate is 40%, then the investor has earned $24 after taxes. In a 1% AUM account, we're going to be charitable and assume that the fees are applied to the $1,024 if taxes are paid from liquidating investments (not likely — they'll probably be paid from income or liquid assets, which would further reduce net return). That's an additional $10.24 in fees. Now, the investor is left with just $13.76 or a 1.376% return. The inflation rate in 2017 was 2.1%. And this is just the index, so we're not counting ETF or mutual fund fees that would further reduce the purchasing power of bond investments.
What about municipal bonds? Munis aren't that much better, and the risk of munis today is worth its own column (exemption from federal taxation is surprisingly reversible, and risks of pension liabilities can't be ignored). Today's return on Barclays long-term municipal bond index is up to 2.74%. An investor who starts the year with $1,000 ends up with $1,027.40. At a 1% fee on AUM, that's $10.27 in fees, so now you're down to $1,017.13. That's $3.37 better at a 40% tax rate on a $1,000 investment, but I'd argue that long-term munis are riskier than long-term corporates. Again, we're not including fund fees.
It's worth pausing for a moment to acknowledge how much a 1% fee on AUM eats up bond returns in a low-yield environment. For corporate bonds at today's rates, fees are 43% of net, after-tax returns. For long-term municipal bonds, fees are 37.5% of returns. For a portfolio that's 50% bonds, an adviser is levying a 40% fee on half of a client's gains.
One of the points of this depressing exercise is to remind advisers that some alternative bond-like investment strategies in which institutions invest bonds in tax-deferred accounts are surprisingly attractive.
There are now two insurance companies that allow investors to accumulate assets in portfolio annuities that invest in a diversified mix of intermediate- to long-duration bonds. These portfolios kick out a dividend that historically has matched a long-term corporate Aaa bond (but is smoothed, so it doesn't have much annual volatility). At retirement, these portfolios are turned into income that provides a significantly higher and safer after-tax lifestyle than a bond ladder of the same magnitude.
Although often maligned, cash value in life insurance policies can also provide a significantly higher net return on bonds than a managed bond portfolio (especially in a low-return environment).
In a recent study, Morningstar compared the actual historical net growth on a plain-vanilla cash value policy of a large mutual insurance company to a taxable bond portfolio and found that the net return was comparable between 1982 and 2016 for a higher-income client without even considering the mortality protection provided by the policy.
In other words, had the client bought a temporary term policy during their working years, they'd have ended up with significantly less in their taxable bond portfolio than they would have accumulated in cash value if they had bought the whole life policy. It should also be noted that all those term premium payments could be applied to basis in the policy, which would further increase the tax efficiency of cash value in retirement relative to a taxable bond account.
Of course, an optimal asset location strategy is to shelter bonds and keep equities in taxable accounts. This isn't always possible for a higher-income, risk-averse client. In a low-return world, fiduciary advisers need to give some thought to alternatives to AUM bond portfolios.
Michael Finke is chief academic officer of The American College of Financial Services, which has educated one in five financial advisers across the U.S. David Blanchett is adjunct professor of wealth management at The American College and head of retirement research for Morningstar Investment Management.