‘In this world nothing can be said to be certain, except death and taxes.’ – Benjamin Franklin
One of the biggest differentiators of long-term investment performance is cost-drag. If you’d invested $1m into the S&P 500 twenty years ago at a total cost drag of 1% p.a., your investment would be worth over $5.5m today. The same investment made at a total cost drag of 3% p.a. would be worth just over $3.7m today, a difference of nearly $2m. By saving just 2% p.a. in costs you’ll increase your final investment by 50% over 20 years / 30% over 10 years. While those percentages are consistent regardless of investment performance, the absolute dollar amounts will depend on the realized returns. The following graph demonstrates this visually.
The lesson here is that seemingly insignificant numbers compounded regularly add up to very significant numbers over time, which is why cost-drag is such an important consideration when making investments. An annual platform fee of 0.5%, plus 1% advisory fee and 1.5% for the underlying fund is commonplace and very quickly adds up. Not to mention the possibility of upfront fees, high trading costs, taxes, feeder funds/fund of funds structures, wrappers, trusts, etc… If you wonder where your investment returns are going, look no further than the various layers that separate you from your investments. You may be one of the many investors paying between 3%-5% p.a, when you could just as easily be paying closer to 1% or even less for essentially the same underlying investment. The difference is not insignificant.
Why the Extra Layers?
The question then arises, how do so many investors end up paying so much? The answer is very often ‘tax-efficiency’. Those inverted commas are appropriate tweezers for handling this expression, since many (but certainly not all) of the methods/products which are touted as ‘tax-efficient’ bear resemblance to some other things you’d rather not pick up with your bare hands. To be clear, the intention isn’t to lump good tax advice under a negative label, but rather to warn against a common pitfall when making investments which trips far too many investors up. This pitfall follows a general pattern.
The thinking goes like this: Tax numbers are usually big one-off numbers like ‘40%!’, while fees are small numbers like 0.5% or 1% or 2% (or even 0.5% + 1% + 2%) compounded annually. An inordinate focus is placed upon the scary headline number, often misrepresented/misapplied without considering the important qualifiers. These big numbers are usually only partially mitigated or even worse, only deferred until later, while the small numbers are seen as barely worth mentioning – they’re so small afterall. But do the math properly and you’ll find that in many cases the small numbers far outweigh any supposed mitigation of the big numbers. Taxes, as Benjamin Franklin suggested, are notoriously difficult to ‘mitigate’, whereas fees add up all too easily.
That’s the general principle, now for some practical examples…
SITUS: A Practical Example
If you’re a global investor you’ve probably heard the word SITUS. This is an estate duty levied on foreign investors in the UK/US. The rate is 40%* in both cases, which is very high. The threshold levels are GBP325k and USD60k* respectively (asterisks intended). Those are the big headline numbers that get thrown around in investment circles. The two most common ways of mitigating these taxes are by way of offshore trusts (which are used for other purposes too) and life wrappers. These aren’t inherently bad solutions, unlike some other questionable products being marketed under the banner of ‘tax-efficiency’. But they are all too often being used by investors who have no need for them, needlessly incurring extra layers of fees that will do more damage to their future estates than any taxes will.
Both of these structures work by limiting the estate duty/donations tax to local rates, saving at best 15%-20% for South African investors – not 40%. Further US SITUS works on a sliding scale that starts at $60k and 18% and peaks at $1m and 40%. Note how the focus is always placed on the lowest threshold combined with the highest tax rate? This is misleading – the two don’t go together. The supposed benefits of these structures are often assumed to outweigh the added costs, and in some cases they may, but this isn’t always the case.
Consider an investor with a $500k/R18m global stock portfolio. If this is a well-diversified portfolio, chances are it is invested roughly 50% in the US and 10% in the UK. The UK SITUS threshold is irrelevant in this case. The US SITUS scale would come out at around 20%, compared to the South African rate of 20-25%. (Note: There is a tax treaty between US/SA so you wouldn’t be taxed twice.) There would no tax advantage for this investor, however there would be significant added costs especially if you factor in the half of the portfolio held in jurisdictions where estate duty isn’t levied. In those cases you’d be taxed in South Africa regardless. Even if you made significant growth assumptions over a long period of time, the added costs would in most cases outweigh any potential benefits for a portfolio of this size. There are a lot of cases where it would be better to incur SITUS than to incur the added costs to avoid it. These are straightforward calculations to run.
To be fair, there are other side-benefits to some of these products (favourable CGT rates, no executors), but there are also other disadvantages (loss of flexibility, higher withholding taxes, added complexity) to be considered. All too often we have only the benefits in mind, with little consideration of the added costs/disadvantages – they’re simply assumed to be justified when often that isn’t the case. All the relevant factors should be weighed up through thoughtful analysis on a case-by-case basis and compared to alternatives rather than treated as a one-size-fits-all solution. There is a legitimate place for these products, but it’s usually for much bigger investments than they are often being applied to, and specifically for investments which are US/UK domiciled when SITUS is the main concern being addressed.
What are the Alternatives?
There are several free/low-cost alternatives to be considered when it comes to SITUS mitigation:
- Don’t put assets that aren’t subject to SITUS, or fall below critical thresholds, in a wrapper that is primarily designed to avoid SITUS. You’re needlessly incurring an added layer of costs on those assets when you do this, without the benefit. This includes many unit trusts and ETFs, non-US/UK stocks, etc.
- Consider investing via a joint account where possible. This effectively doubles the threshold levels rendering them irrelevant for many investors. The above example of a $500k/R18m portfolio then applies to a $1m/R36m portfolio.
- Weigh the use of UCITS ETFs for US/UK exposure above certain levels. These are not subject to SITUS. These can also be used to augment an active portfolio of specific US/UK stocks for larger portfolios.
Saving 1%-2% p.a. in cost drag for essentially the same underlying investment with the same tax benefit is a win-win.
The Tax-Deferral Mirage
Often tax mitigation amounts to nothing more than tax deferral, which is like a mirage promising something in the distance that vanishes when you get there. Consider the following mathematical identity:
Whether you pay tax at the beginning of an investment, somewhere in the middle or at the end makes absolutely no difference to what you end up with unless the tax rates differ. You might have heard someone say that ‘you earn the returns on the larger pretax amount’ but mathematically this makes no difference because the same tax rate applied to a larger terminal amount means you pay more tax at the end and end up at the same place.
Don’t trick yourself into thinking that pushing a tax liability out into the future is somehow beneficial, especially if the means of doing so incurs an added layer of fees along the way. Some retirement products would fall into this category. Even if the tax rates differ, the difference needs to be very significant to outweigh the drag of an added layer of fees, not to mention the loss of flexibility and added complexity that often comes with these solutions.
Capital Gains Tax Roll-Up: Another Example
Most investors hate paying capital gains tax (CGT). They would rather hold onto an overpriced asset and risk a poor return than sell it and incur CGT. Or they’d prefer to hold their shares in a unitized structure, where the underlying portfolio trades don’t trigger CGT, effectively rolling the CGT liabilty up until the units are finally sold. This is an example of CGT tax-deferral that is generally regarded as good tax practice in South Africa, and the cost isn’t necessarily any different. But does this really make sense?
The reality is that the deferral itself adds no value, because the tax rates are the same whether you incur them along the way or pay them at the end. In fact, in South Africa, CGT deferral has yielded negative value, because:
- You miss out on the R40k annual CGT allowance (R80k if you invest via a joint account), only taking advantage of it once at the end of the investment. The longer the investment duration the bigger the difference.
- Wealth taxes in South Africa have been rising, which means that deferred gains have attracted higher tax rates. If this trend continues, deferral will continue to have negative value.
As for holding onto overpriced assets because of resistance to incurring CGT… The fact that the CGT liability doesn’t show on your investment statement doesn’t mean that it isn’t there. If you have two assets with the same carrying value of $100k on your investment statement, but the one has a cost basis of $10k and the other a cost basis of $90k, the latter is actually worth more to you because it carries the lower tax liability.
The lesson: Don’t allow CGT to rule over all other considerations in your investment decision making.
In summary, when considering the ‘tax-efficiency’ of your investments, make sure you also consider overall cost-efficiency. Small numbers compounded regularly are often more detrimental than big one-offs. Are the added layers between you and your investments adding value? Always do the math before swallowing the conventional wisdom.