Archive for the ‘Mutual Fund Regulation’ Category


Reforming the Mutual Fund Tax Loophole

March 16, 2009

Important changes to our income tax structure are right around the corner. Increased government borrowing will exert pressure to find additional sources of revenue, and most of this additional revenue will be generated by increasing taxes on individuals. For those of you who have read my previous blog posts or publications, you know that I favor consumption taxes relative to income taxes, but let’s set this aside for the moment and examine one not-so-small, but highly under-publicized, loophole in our current tax system.  That is, the implicit ability to deduct the management fees that mutual funds charge their investors.

By deducting fees from fund assets mutual funds essentially disguise the fees that individual investors pay.  If you hire a money manager, or a financial planner, you cannot deduct the fees that this professional charges you from your investment returns. If you get a 10% return on your money and the money manager charges you a 1% annual management fee you pay taxes on the entire 10%. Because mutual funds deduct fees from assets before calculating return the tax situation is different. If your gross return from a mutual fund is 10% and the mutual fund charges you 1%  annual management fee you pay taxes on the net return — that is 9%.

This is a bigger money issue than it may first appear.  The aggregate net asset value of mutual funds shares held in the U.S. is about $10 trillion.  About half of this amount is held in non-tax-deferred accounts. So, the returns on about $5 trillion is exposed to taxes. The average mutual fund, considering both stock and bond mutual funds, charges about a .90% annual management fee.  That suggests that investors are paying about $45B a year in tax-exempted mutual fund management fees. If the average taxpayer pays a marginal tax rate of 25%, a simplifying but effective assumption given my purpose here, what you have is a little over $11 B that is not flowing into the government coffers that by all rights should be.

Why is this tax break particularly troubling to me?

  1. A tax deduction for money management is massively regressive.  The more money you have, the bigger the tax break you are getting.
  2. It is a loophole that is easily exploited. Wealthy individuals can, and do, pool their money with a reasonably small group of other individuals and legally start “mutual funds.” These funds are not marketed to the general public. They are constructed as legal tax shelters generated in order to allow their limited membership to deduct the cost of money management.
  3. Because no taxes are paid on the fees, many mutual fund shareholders will pay less attention to the fees that they are charged. If fees were made explicit, and taxes paid on the gross rather than the net returns, individuals would undoubtedly pay more attention to the fees charged and many people would be made better off for it.

The forthcoming overhaul of financial regulations should not focus exclusively on institutional transactions, but should grapple with needed changes in the retail market for financial services as well. Informed regulation of the financial markets and revisions in the tax code are inextrcibly intertwined. One focus of good regulation should be to close obvious tax loopholes. What I have written above is one example of a change long overdue.


PBS Interview — Your Investments with Adam Bold, Part 2

August 24, 2008

Adam Bold, founder and Chief Investment Officer of the Mutual Fund Store, invited me to do an interview for his PBS show “Your Investments with Adam Bold.” Although filmed at the same time as the first interview with him I posted this material aired on a subsequent episode of the show. In the interview I discuss some steps the federal government could take to increase savings, as well as other issues surrounding savings. 


The Dangers of Embedded Tax Liabilities in Mutual Funds

July 30, 2008

This post continues a discussion I’ve forwarded about the inadequacy of current mutual fund disclosure regulation. In a previous post I’ve talked about the need for additional disclosure about mutual fund fees.  Now we turn our attention to taxes, and how unsuspecting mutual fund investors can be saddled with a tax bill they had no part in creating.

If you hold shares in a mutual fund outside of a tax-deferred retirement plan you no doubt receive information each year on the amount of money the mutual fund distributed to you in the form of taxable dividends and/or capital gains. For a detailed explanation of how mutual funds create tax liabilities click here. What mutual funds are not required to disclose is their potential capital gains tax liability. And at risk of boring you to tears I am going to provide a simple example so that (hopefully) it is clear why this matters.

Suppose a mutual fund company currently owns two shares of the company HiTech. The shares were purchased by the fund at $5 per share and are currently selling for $10 a share. The fund has issued two shares of its own, owned by Bill and Mary. The current net asset value per share of the fund is thus $10 per share.  Now suppose Ron buys a share of the fund for $10. The fund uses the proceeds to buy another share of HiTech. The fund now owns three shares of HiTech with acquisition costs of $5, $5 and $10.

Now suppose the stock of HiTech drops to $9 per share. This drop causes the net asset value per share to drop to $9. Bill and Mary decide to redeem their shares. To meet this redemption, the fund sells two shares of HiTech with the cost basis of $10 for one share and $5 for the other. This generates a realized capital gain of $9-$5 = $4 for the share purchased at $5 and a realized capital loss of $1 for the share purchased at $10. So, there is a net captial gain of $3. This capital gain must, by law, be distributed to the remaining shareholders. So, in this case, Ron recieves a capital gain distribution of $3. The net asset value of the fund falls to $6 per share and, assuming reinvestment, Ron now owns 1.5 shares.

Although Ron has experienced an investment return of -10%, he will still face this capital gains tax. If capital gains are taxed at 15% he must pay 45 cents in taxes. So, even though Bill and Mary walked away with the investment returns, Ron gets left holding the tax bag and must pay the federal goverment the taxes that Bill and Mary’s investment returns created.

Some mutual funds, particularly equity mutual funds, have large embedded tax liabilities of just the short described here. If they needed to sell assets quickly to generate cash those who did not exit the fund right away would be stuck holding the tax bag. Most people don’t know much about what I’ve just written here, but you can bet that if it happened at large enough scale (like during a sizable economic downturn) the press would quickly notice it and that investors would quickly exit these mutual funds — in a way not altogether different than a bank run — to avoid these tax implications.

At a minimum, individuals should be given information sufficient to determine whether a fund they are thinking of investing in has a large or small embedded tax liability. Without this disclosure, there are serious and often-unknown financial risks to savings invested in mutual funds. The SEC should mandate this disclosure. If they do not, the House Financial Services Committee should write legislation requiring the SEC to do so.



June 19, 2008

As Baby Boomers approach retirement some of them will consider annuitizing their money, making a lump sum payment in return for a constant income stream for the rest of their lives. That’s a good idea for many of them. Classic research suggests that almost everyone should annuitize some (or even all) of their money as they enter retirement and more recent research finds evidence that people are often happier when they have an annuity in retirement.

That’s all well and good but many annuities are purchased with the help of a financial advisor and herein lies a serious problem in this marketplace.  Financial Advisors/Planners are often compensated as a proportion of the assets they are managing. For example, they might charge you 1% of assets annually. Once they sell you an annuity that money essentially vanishes for them. The money is now being held by the insurance company who is obligated to make payments to you. Even if they receive a commission for the sale, they have now given up 1% of those assets for potentially many years going forward.

So, what do you think happens in this situation? You guessed it, despite their fiduciary responsibility to do what is in their client’s best interest many are reluctant to advise people to purchase annuities. The industry buzzword for this behavior is “annuicide.”

Annuities are yet another example of an issue I have brought up before on this blog. Federal oversight in many of these financial services marketplaces is woefully inadequate. We need some individual legislators to make disclosure and regulatory oversight in these growing marketplaces a priority.


Into the Wild

June 11, 2008

In his book The Great Risk Shift, Jacob Hacker describes the transformation of American society from one in which government and private businesses protect citizens and employees from many risks to one with a much more libertarian ethos, every man for himself. Hacker argues that we have moved too far towards this view, and that civil society would be better off with a return to more risk sharing among citizens, businesses and the government — particularly in the areas of health care and pensions.

Hacker is more enamored with top-down federal government solutions than I am, but much of what he says rings true. Americans, more than at any other time since the Great Depression, are asked to shoulder the burden of providing for their income in retirement. They face this task by confronting a bewildering array of investment options, risks that are difficult to gauge, and costs (fees) that even sophisticated investors would have difficulty explaining. And these products are all-too-often marketed by individuals that act as faux-fiduciaries, easily convincing otherwise-intelligent people that they have their best interests in mind when that is not always the case.

It is not the government’s responsibility in these situations to make people’s decisions for them. But it is their responsibility to ensure that individuals of middling financial sophistication at least have information presented them in a way that allows them to make a reasonable choice for themselves. The Federal Trade Commission demands a high level of product and price transparency when we enter the grocery store, but the same cannot be said for the market for financial services. Today’s employee and tomorrow’s retiree heads into this wild marketplace with little confidence that what they see is what they get. And they have good reason to feel that way.

Federal disclosure regulation for insurance, mutual funds, mortgages, annuities, and even some markets for basic assets such as bonds are so far out of date it almost hard to overstate their impotence. This lack of transparency has two important effects, some people are sold products and services they don’t need or worse yet do them financial harm while others do not enter markets that might be beneficial to them. The first part of this problem has garnered some modicum of attention in media, but the second has not. Lack of transparency and its associated confusion causes some people who should own stock mutual funds not to own them, some who should have a life annuity as a part of their retirement income plan not to have it.  This is a powerful, but hidden, cost of this problem.

People of good will can disagree about how much risk should be born by the government and how much of life’s risks and rewards should be left to the individual, but regardless your political views it is absolutely essential that to the extent we vest individuals with these important decisions we compel those who seek to affect their choices to provide them with clear and correct information — the kind that can be read by normal human beings and not just attorneys. Transparency in these marketplaces needs to be a priority of whichever administration takes office next January.


The SEC Should Act on Fee Disclosure Regulations for Financial Services

May 21, 2008

One clear lesson rising from the ashes of the sub-prime mortgage mess is that it is difficult to change the rules of the game once all interested parties think they know them. The Bush Administration’s narrowly focused bailout of some borrowers has been widely criticized as catering to business interests at the expense of cash-strapped homeowners. The government’s unfortunate task in these kinds of situations is to decide who loses money, homeowners or the multitude of businesses and individual investors that knowingly or unknowingly hold low-quality mortgage-backed securities.

It is easy to be sympathetic to affected homeowners. In many cases, even if one could argue that they should have understood the implications of the variable rate and other exotic mortgages they were signing, they clearly did not. And it is difficult to blame them. Mortgage financing is about as clear as mud to the average family looking to purchase a home. This lack of transparency leads to poor decision-making. Poor decision-making leads to public angst and the aftermath of government bailouts. Much like the Enron-era accounting scandals, it is too late to save some people from financial distress. But we can look closely at the harsh lessons of this crisis with an eye toward creating reasonable protections for people who enter the increasingly complex market for financial services. Are there other sectors of the financial markets that suffer from the same staggering opaqueness as the mortgage market? You bet.

Most people have almost no idea how much money they are being charged by the mutual funds contained within their company-sponsored retirement plans. The regulations governing mutual funds, set by the U.S. Securities and Exchange Commission, foster this ignorance. The General Accounting Office has recommended changing disclosure laws to require investment management companies to tell investors how much, in dollars, they are being charged. Under pressure from financial industry lobbyists, that information has not been revealed. The result is tepid price competition in the mutual fund industry, and a slow but steady drain on the retirement savings of millions of Americans — even though most are completely unaware of it.

The market for annuities, a popular product among those preparing to retire, can also be very confusing. Its mystery is shrouded by complicated insurance speak that may be well intentioned but is not accessible to most retirees. Some retirees fork over a substantial proportion of their life savings to these products, sold on the merit of apparent safety, without understanding the risks macroeconomic events can pose. For example, the holder of a simple fixed-payout life annuity could see the real earning power of his or her steady monthly payments plummet if inflation suddenly lurched upward and remained at that higher level for a few years. If the problem were widespread would there be calls for some kind of government bailout? Who could doubt it?

Mutual funds and annuities are just examples of perfectly good investment products sold by many well-intentioned companies that, due to woefully inadequate disclosure laws, can be abused by some institutions that market them. The creativity and flexibility of our financial markets have outstripped the creativity and flexibility of those charged with ensuring that consumers and investors who make reasonably diligent efforts to understand the products and services they are being offered can do so.

We need bold reform in financial disclosure regulation. The costs of the financial products and services many Americans purchase should be made absolutely apparent, even to those without any financial background whatsoever. It would increase individuals’ ability to understand these marketplaces, to shop around, and ultimately encourage healthy competition in both price and service quality. Perhaps more importantly, it would lead some people whose bewilderment about financial matters keeps them from entering financial markets that might be beneficial to them to enter those markets. Commercial law requires price transparency when we go, for example, to the grocery store to purchase a gallon of milk. The stakes in financial markets are much higher than they are at the grocery store, and yet financial institutions aren’t required to divulge their prices to you. Americans of all economic strata are being asked to shoulder an increasing portion of the burden of their own economic well-being in retirement. And most of us are not going about the task very effectively. The seeds of a future government bailout should be obvious. Government regulatory agencies need to learn the lessons of the subprime lending crisis and act now to stem the rampant disparity between what we know and what we ought to know before we enter the ubiquitous financial marketplaces. The hard-earned savings of many Americans depend on it.