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3 Critical Aspects of Household Rebalancing: Location, Location, Location

It’s all about seeing the big picture.

Clients are expecting more from their advisors and advisors are responding by shifting away from managing accounts individually towards providing holistic advice at the household level. As the number of accounts per client has increased, the ability to manage portfolios stretched across multiple registration types with a mix of taxable and non-taxable accounts has become critically important.

Today’s investors tend to own five to six accounts with a range of registrations and product types, according to research by the Money Management Institute (MMI). Due to the increasing complexity of client portfolios driven by their desire to diversify, they need to optimize their full household portfolio in order to reach their intended goals.

Unfortunately, most portfolio management applications are not able to provide key features such as tax aware rebalancing across a group of accounts. Advisors and portfolio managers are then forced to manually place securities in the most tax efficient locations, which can never be as efficient as an algorithm. This results in clients paying more in taxes than they should, but they don’t know it!

Location optimization is how advanced portfolio rebalancing tools decide where to place each asset in a household of accounts. It includes the client’s tax rate, the level of tax efficiency of each security and the taxable state of each account when making decisions. On top of all that the software also must account for specific client restrictions as well.

The Difficulties of Account-Level Management

At the heart of portfolio rebalancing are the assumptions that each client is assigned a target investment strategy and may have one or more restrictions that prevent the model from being replicated in every account. Layering these on top of the myriad of account registrations with different tax treatments causes the level of rebalancing difficulty to explode exponentially.

Most rebalancing software can handle this complexity only at the individual account level, which is why many advisory firms are stuck managing each account separately, without regard to the holdings in a client’s other accounts. Account-level rebalancing tries to recreate the assigned model in every account, regardless of whether it is taxable, tax-deferred or tax-exempt.

For advisors who still manage their portfolios manually, account-level management is much easier than household-level management. It’s not necessary to try and organize multiple accounts with a single model and for clients, it’s easier to understand their statements. Their performance will be consistent across all of their accounts, since they all hold a similar mix of securities. This avoids dealing with difficult questions such as, “Why did my taxable account outperform my IRA?”

While account-level management is quite convenient for both advisors and clients, it has a number of serious disadvantages. Since you’re unable to place investments in specific accounts in a client’s portfolio, you miss opportunities to for tax reduction. And because clients are forced to hold the same allocation of investments in every account, it is often necessary to buy or sell duplicate positions in a family’s accounts.

This is why every firm should be using rebalancing software with a level of intelligence that can juggle all of these factors and determine the optimal solution for every account across an entire household. Only by using software that rebalances at the household level can you be sure that you’re always acting in your client’s best interests.

Household-Level Rebalancing

Unlike account-level management, in household-level rebalancing the model is represented in aggregate with the full investment allocation spread across a mix of taxable and non-taxable accounts. The software is able to place specific investments into the account type that provides the best tax treatment. This is location optimization in a nutshell.
That said, if your client meets these basic criteria for location optimization, you can reduce the overall tax burden by carefully selecting which investments are held within each type of account as long as the combined account holdings match the model. This is much more efficient than placing a full allocation within each account, since it reduces the number of trades required.

When the Time and Place are Right

A client’s need for income and their tax bracket should also be considered when making location decisions. While basic location optimization will direct investments that generate dividends or interest into non-taxable accounts, it doesn’t consider the client’s current tax rates or their expected future tax rates. When the relative cost of income tax versus capital gains tax is taken into account, the opposite conclusion could be reached.

Additionally, current tax rates have to be reviewed when estimating how much net income their accounts will generate. While bonds are generally expected to have lower returns than stocks, if the bonds are held in a taxable account, the income from bonds will be taxed at a higher rate — the client’s income-rate tax, not their capital gains tax rate.

The calculations become more complicated due to some of clients’ accounts having different time horizons that can change due to life events. If one spouse decided to retire early, what will the household income tax rate be at that point, and how should their assets be relocated to optimize the after-tax income?

Assuming that you rebalance accounts to their assigned models at least annually, to properly consider all of these variables requires many iterations to find a tax-optimal portfolio. And to your client, every basis point matters.

A properly designed household-level portfolio should generate the right amount of capital appreciation for the long term and the right amount of income in the short term. To do this, you need robust iterations of all of the possible location scenarios while taking into consideration the tax efficiency of each security and every type of account your client has. Rules of thumb and back of the envelope calculations won’t suffice.

Finding the Right Software Solution

With location-based rebalancing software, an advisor can input all of the relevant variables and let the computer crunch the numbers. The tax-optimal locations are calculated for each position and the most tax-efficient trades are generated to rebalance the portfolio.

What is missing from most rebalancing applications is the ability to compare different locations for multiple positions across accounts in various combinations. Households with ten or more accounts and a model with twenty positions would have thousands of permutations to evaluate. Multiply this by the number of households at the firm and the problem becomes monumental.

The right software would be one that is based on algorithm that can iterate through the thousands of options and determine the best one for each household. This should be a requirement for every advisory firm that uses portfolio rebalancing software.

The top software packages enhance these processes by also considering the compromises necessary when evaluating between trading less and generating lower transaction costs and trading more, with higher costs, but delivering a closer match to the target portfolio.

For example, if both a bond and a stock held in taxable and non-taxable accounts have significantly outperformed the market, depending on your client’s tax position, it may make more sense to sell more of the bond in the taxable account and less of the stock in the non-taxable or vice versa. Either way, the result for the household is returning the portfolio to the model, in the most tax-efficient way possible, with the lowest transaction costs. Lower costs boosts your clients’ total return.

Some estimates put the added value of location optimization at between 20 and 50 basis points per year, which is more alpha than many professional managers can make through good asset allocation. And 20-50 basis points could easily be half of your management fee. Imagine being able to tell your client that your software was sophisticated enough to earn them half their management fee, just through location optimization.

Working with Your Clients

Your client may not realize the cost of selling one security in one account only to buy it in another. Yet it happens all the time in household rebalancing. Your client may also not realize just how many transactions (in each of their accounts) may be required to fully rebalance all of their portfolios after a significant market move.

It can often be difficult to have clients understand the tradeoffs that have to be considered. Would they prefer precise model replication at each quarterly rebalancing, or are they willing to accept a little more tracking volatility in order to reduce transaction costs? With location optimization software, you can quantify that cost quickly, and show them how treating their household as one portfolio — while still placing each security in its tax-optimal location — can reduce that cost.

Softpak’s Solution

As a leader in rebalancing software for over fifteen years, Softpak has developed an extremely powerful location optimization solution. Unlike other providers, our software has no limitations on the number of accounts it can manage in a household, which is perfect for high-net worth clients. Additionally, our broad list of individual security rules can support the most complex high net worth households.

uRebal from Softpak automatically considers location optimization when rebalancing and simultaneously prioritizes tax efficiency while minimizing the number of trades. It determines the best locations when buying or selling and scales to thousands of accounts or more to support the largest client bases.

Click on the link below to have a Softpak representative contact you with more information about our household rebalancing solution.

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