Financial Professional Outlook

Financial Professional Outlook Tracking the opinions, conversations and market sentiment of U.S. financial advisors since 2010. Why taxes? With new tax laws taking effect in 2014, we thought it was a good time to talk about tax-aware investing. For many investors, taxes can seriously detract from an investment portfolio s return if not managed effectively. For instance, the average actively managed U.S. equity fund gave up 1.26% annually to taxes over the last 5 years. 1 What s more, this year s new laws will mean higher federal taxes for many investors. The current survey was fielded from February 27 to March 7, 2014, and we heard from 173 advisors working for nearly 100 firms across the country. Overall, advisors expressed a strong interest in managing the impact of taxes on their clients portfolios. Still, taxes can be a confusing and somewhat uninspiring conversation topic. We see this play out in the Financial Professional Outlook survey, where only 29% of advisors said they ve initiated a conversation about tax implications with their clients in the last quarter. That number was even lower for clients, as just 10% of advisors said clients raised the subject (Exhibit 8). Yet a large majority of survey participants (86%) said tax-managed investment strategies are important, or critical, to their businesses. In this report, we will examine advisors views on tax-aware investing and several key tax strategies from a number of angles. Among them are the tax-managed products advisors recommend most often and the methods advisors use to calculate after-tax returns, as well as our own views on how advisors can add value amid a dynamic and complex tax landscape. Finally, we ll take a look at market sentiment and the top conversations between advisors and their clients. DATE April 2014 AUTHOR Frank Pape Director of Consulting Private Client Services 1 Actively managed U.S. equity mutual funds as reported by Morningstar as of 12/31/2013. Data excludes index funds. Not FDIC Insured May Lose Value No Bank Guarantee Russell Investments // Financial Professional Outlook p / 1

1 Managing taxes: a big deal for most, but not all, advisors. The majority of advisors (86%) said tax-managed strategies are important or critical to their business and 77% said they re important to their clients. So taxes are indeed a big deal. Respondents roughly fit the normal distribution pattern (bell curve), falling into one of three categories that we call Experts, Believers and Unmotivated. EXHIBIT 1: IMPORTANCE OF TAX-MANAGED STRATEGIES TO BUSINESS Describe the importance of tax-managed investment strategies to your business. EXPERTS BELIEVERS UNMOTIVATED 50% 40% 30% 20% 10% 0% Critical: Core of my value proposition Very important: Significant part of how I serve most of my clients Important: Make available to high net worth clients Somewhat important: Make available to those requesting it Not important: My clients don't benefit EXPERTS The 11% who said tax-aware strategies are critical to their business are fully engaged on the subject and likely have a greater number of high net-worth clients interested in the topic. As you might expect, experts appear to have a firm grasp of tax-aware strategies and how to implement them effectively. BELIEVERS Most advisors (75%) fall into this middle category and said they make taxmanaged investments available to most clients or their high net-worth clients. Believers are looking to learn more about tax-aware investing, seeking information to share with clients and planning tools to help them succeed. They also expressed an interest in developing stronger relationships with their clients tax professionals. UNMOTIVATED These advisors (14%) either don t offer tax-managed solutions or provide them only to those who request it. It s likely that advisors in this category work with clients who have fewer assets. They may also be serving clients with mostly qualified or non-taxable accounts like 401(k)s and IRAs, so there would be little need to focus on managing taxes. 86 % OF ADVISORS BELIEVE Tax-managed investment strategies are important to their businesses. Russell Investments // Financial Professional Outlook p / 2

2 New tax strategies for a new tax year. The first thing you ll notice about the chart below is that it looks surprisingly similar to the previous one. This time, an impressive 91% of advisors said using new or updated tax strategies is important to them in 2014. Taxes are clearly getting more attention this year as an increasing number of advisors begin to understand the impact of the new laws. EXHIBIT 2: IMPORTANCE OF IMPLEMENTING NEW OR UPDATED TAX-MANAGED STRATEGIES THIS YEAR Given some of the tax policies that take effect in 2014, how would you describe the importance of implementing new or updated tax-managed investment strategies with your clients this year. EXPERTS BELIEVERS UNMOTIVATED 50% 40% 30% 20% 10% 0% Critical: Most important thing this year Very important: Top 2 or 3 priorities Important: Will do with some clients Somewhat important: Will do if asked Not important: Don't plan to implement There could also be another factor at play here. That s the possibility that last year s big gains in the equity markets and underperformance in the bond markets have left many portfolios out of balance with their asset allocation targets. 2 In taxable accounts, rebalancing has the potential to be costly, as equity gains are realized (and taxed) and those assets are then reallocated to fixed income investments. Tax sensitivity is becoming a very real issue as more investors build wealth, which is why it s becoming so important to advisors. We believe that advisors who can continue to move along the continuum from Unmotivated to Believers and Believers to Experts can reap the greatest rewards from this trend for their businesses while providing a valuable service for their clients. 2 http://www.morningstar.com/cover/ videocenter.aspx?id=641238 Russell Investments // Financial Professional Outlook p / 3

3 How do you calculate after-tax returns? This open-ended question in the Financial Professional Outlook seems to have stumped a good many advisors. While we saw a wide range of answers, most advisors (38%) didn t submit a response at all. So were those advisors unsure how to perform the calculation? Possibly, or perhaps the question was too difficult to answer? That s very likely, but more on that later. In any case, 16% said they don t calculate after-tax returns, with a portion noting they mostly work with qualified funds. Others said they used software or a service (6%) and a few said someone else did the calculations (5%). Of the remaining answers, several mentioned they apply a client s marginal tax rate to the investment return. In our view, the after-tax return should focus on the actual distribution for that year not the rate of return. For example, if the investment return was generated through a price increase in the underlying security without an actual distribution or realized gain, this unrealized gain does not owe any taxes at this time. And having the ability to defer gains can have a powerful compounding effect over time. EXHIBIT 3: METHODS USED TO CALCULATE AFTER-TAX RETURNS How do you typically calculate after-tax return for a high net worth client s total portfolio? Sentiment Percent Did not answer 38% Advisors who don t calculate after-tax returns or mostly work with qualified funds 16% It depends; do it manually; or evaluate client s portfolio 9% Based on the tax rate; the tax bracket; the combined rage; the effective rate; or the total return minus the tax rate Use software or a service 6% Deduct federal and state taxes before calculating return 5% Rate of return times 1 minus the tax rate; or return times the reciprocal of the marginal tax rate Someone else does the calculations (in house or elsewhere) 5% Deduct dividends and /or capital gains 4% Other 6% 8% 5% ALL RETURNS ARE NOT EQUAL. Another small number of advisors said they look at a client s total return and apply the client s tax rate to that number. In this case, the tax is only applied to the distribution, not the appreciation. So once again we see that all returns are not equal. You have to consider how much of the return comes from appreciation versus distributions to get an accurate calculation. Then you must take into account the character of the distribution. Was it short- or long-term? Can you offset any gains with losses? Russell Investments // Financial Professional Outlook p / 4

3 CONTINUED THIS QUESTION GOT US THINKING. In retrospect, this was likely a challenging question to answer in a short survey. But we believe this is a very important issue, and one that many advisors may not be approaching in the optimal way, or at least not with confidence. Since this is such a worthwhile and easily misunderstood topic, we ve written a post on our Helping Advisors Blog to walk you through the aftertax return calculations. We also cover some basics that advisors need to know about their clients tax status. It s not all-inclusive, but it should help advisors better approach calculating after-tax return numbers. Visit the Helping Advisors Blog to read more about tax-aware investing topics, such as how to calculate after-tax returns. 4 Top tax-aware products favored by advisors. Advisors use a variety of products to try and gain tax efficiency for their clients. At the top of the list were tax-managed mutual funds (31%), municipal bonds (25%), and separate accounts (16%). Tax-managed mutual funds are a natural choice thanks to their ease of use, sensitivity to portfolio turnover, and ability to balance distributions with capital losses. They are also accessible to a wide range of investors, regardless of their wealth status. Separate accounts can also be managed tax-efficiently and use many of the same strategies as tax-managed funds, but often require far higher minimum investments. EXHIBIT 4: TAX-MANAGED PRODUCTS USED OR RECOMMENDED MOST OFTEN What tax-managed products do you use or recommend most often in client portfolios? Tax-managed products recommended most often Percent Tax-managed mutual funds 31% Municipal bonds 25% Separately managed accounts 16% Passive investing through index funds or ETFs 10% Can t choose use a combination of different products 5% Limited partnerships 2% Annuities 1% REITs 1% Other 5% Russell Investments // Financial Professional Outlook p / 5

4 CONTINUED Municipal bonds (munis) have long been a favorite among wealthy investors because the dividends are typically exempt from federal income taxes and most state and local taxes (in the state issuing the bonds). However, 2013 was an interesting year for munis. While fixed income assets as a whole faced selling pressure, municipal bonds were among the worst performers. Fiscal challenges facing Puerto Rico and solvency issues in Detroit were partly to blame for the underperformance. 3 Given the recent increase in tax rates for high income earners, the taxable equivalent yield on many municipals is much more reasonable today versus last year. However, we believe advisors still need to conduct their own due diligence to fully understand the municipal products they re considering for individual clients. One result we found quite surprising was the relatively low use of passive investments among advisors. While some firms in the industry regard index investing as an important tactic in a tax-management strategy, only 10% of advisors said they invest passively through index funds or exchange traded funds. 3 http://www.reuters.com/ article/2014/02/28/us-munis-puertoricoidusbrea1r1sm20140228 5 The advisor/cpa relationship. Many investors who could benefit from a tax-aware investment approach already work with a certified public accountant (CPA) or tax attorney as well as a financial advisor. Because of this, some advisors count on CPAs and tax attorneys as a key partner in addressing their clients planning needs and also as an important source of client referrals. Roughly 60% of respondents say they have relationships with some, nearly all or all of their clients CPAs or tax attorneys. The advisors in the Expert category (or Believers who are nearly Experts) see the benefits of engaging with their clients tax professionals. EXHIBIT 5: RELATIONSHIPS WITH CLIENTS TAX ADVISORS How would you describe the relationships you have with most of your clients certified public accountants and tax attorneys? Relationships with all or nearly all Relationships with some Relationships with only a few Relationships with none My clients rely on my firm for tax advice Other response 0 % 10 % 20 % 30 % 40 % 50 % Russell Investments // Financial Professional Outlook p / 6

5 CONTINUED In our opinion, these advisors recognize the importance of expanding their center of influence for their clients, as well as their business. It s also likely that these relationships are driven by clients who want their advisors to develop stronger bonds with their tax professionals. In fact, 37% of advisors said they wish they had better relationships with their clients CPAs and other tax professionals to enable better conversations with clients on the topic. 6 What else could lead to better tax-managed conversations? 37 % OF ADVISORS Advisors have a long wish list when it comes to helping them have better client conversations about tax-managed investing. Among the top three choices were materials to share with clients (65%), planning tools (44%) and general education on the issues (39%). That s a very hopeful sign. We find the desire to improve relationships with clients CPAs and other tax professionals particularly interesting. It shows that more advisors further down the Believer continuum see the value in improving these relationships. As we said before, it s in everyone s best interest to strengthen these bonds. Advisors who proactively reach out to their clients and their tax professionals stand a good chance of building trust and business. Want better relationships with their clients CPAs and other tax professionals. EXHIBIT 6: USEFUL RESOURCES FOR BETTER CLIENT CONVERSATIONS What resources do you wish you had to enable better client conversations around taxmanaged investing? Materials I can share with clients Planning/analysis tools General education on the issues Better relationships with CPAs, tax attorneys, etc. Product knowledge Access to subject matter experts 0 % 10 % 20 % 30 % 40 % 50 % 60 % 70 % Russell Investments // Financial Professional Outlook p / 7

7 When it comes to tax-managed conversations, advisors try to control what they can. The majority of advisor-driven tax conversations focus on things they can control, like strategies to reduce taxes (64%) and the tax implications of investment strategies (62%). As for clients, advisors say investors tend to approach the topic by focusing on government tax policies or laws (52%). Of course, advisors aren t completely immune to striking up a government policy tax conversation, but these folks are in the minority. In our view, advisors can choose to gripe along with clients about political issues and uncertainty, or they can focus on something more productive. In this case, we believe educating clients about tax-aware strategies may be one of the best ways to add value to client relationships and, ultimately, investment outcomes. EXHIBIT 7: COMMON TOPICS ABOUT TAX IMPLICATIONS OF INVESTING When you have discussions with clients about the tax implications of investing, what are the most common topics that you raise? That your clients raise? 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % 0 % Strategies to reduce or avoid taxes Tax implications of investment strategies Government tax policies or laws Other Advisors Investors Russell Investments // Financial Professional Outlook p / 8

8 The tax implications of rebalancing, and other conversations. Once again, when we asked advisors about the most common topics of conversation with clients, the top advisor choice was portfolio rebalancing (51%), followed by portfolio performance (40%), running out of money in retirement (29%) and tax implications of investing (29%). It s likely there was some overlap between the rebalancing and tax conversations because the equity markets experienced very strong performance in 2013 (up over 27%), 4 while bonds were weak (returning -2.02%). 5 That lopsided performance meant a typical balanced portfolio of 50% stocks and 50% bonds could need to sell some equities and buy more bonds to get back to its target allocation. As a result, investors could owe taxes on their gains while potentially paying a higher tax rate year over year. That s the hard way to learn about tax-efficient investing. For investors, advisors said their main focus was on volatility (55%), portfolio performance (35%) and concerns with government policy (34%). All in all, these responses are in line with what we have seen in previous surveys. 4 Russell 1000 Index 5 https://indices.barcap.com/ show?url=benchmark_indices/ Aggregate/Bond_Indices EXHIBIT 8: WHAT ADVISORS AND INVESTORS ARE TALKING ABOUT When thinking about conversations you ve had with your clients over the past three months, which of the following have been the most common topics of conversations initiated by you? Initiated by your clients? Portfolio rebalancing Portfolio performance Running out of money in retirement Tax implications of investing Estate planning Buying/selling specific investment product Rethinking financial goals Markets going up/down Global events Keeping up with inflation Concerns with government policy Start savings plan for specific purpose Funding financial needs of parents Other 0 % 10 % 20 % 30 % 40 % 50 % 60 % Investors Advisors Russell Investments // Financial Professional Outlook p / 9

9 Advisors still feeling the love for the markets. Advisors don t see much they don t like about the markets. In fact, we saw a new record high in the latest survey with 87% of them feeling optimistic looking out over the next three years. That beats the previous high of 86% set back in February 2011. Only 30% of advisors said clients are optimistic, down from 36% in the December FPO survey. Investor uncertainty, according to advisors, moved up five points to 55%. The optimism gap between advisors and investors widened 14 points to 57% quarter over quarter. Overall, these are pretty typical ranges even with the record-high in advisor optimism. EXHIBIT 9: MARKET SENTIMENT COMPARED WITH THE RUSSELL 1000 INDEX In general, how optimistic or pessimistic are you about capital markets over the next three years? What about your clients? Sentiment Index* Trend: advisor vs investor Sentiment Index (Optimistic Pessimistic) 80% 60% 40% 20% 0% -20% -40% Feb '11 May '11 Aug '11 Nov '11 Feb '12 May '12 Aug '12 Nov '12 Feb '13 May '13 Aug '13 Nov '13 Feb '14 1100, 1,050 1,000 950 900 850 800 750 700 650 600 Russell 1000 Index value * The Sentiment Index provides a point-intime measurement of advisor and investor sentiment about capital markets over the next three years. The Sentiment Index takes into account both those who are optimistic and those who are pessimistic, and is calculated in this way: Sentiment Index = (% of group that is optimistic) (% of group that is pessimistic). Advisor Sentiment Index Investor Sentiment Index Russell 1000 Index 2010 2011 2012 2013 2014 Nov Feb May Aug Nov Feb May Aug Nov Feb May Aug Nov Feb Optimism Gap 51 % 50 % 48 % 59 % 58 % 60 % 56 % 56 % 48 % 52 % 43 % 52 % 43 % 57 % Advisor: Optimistic 59 % 86 % 76 % 72 % 66 % 78 % 76 % 68 % 65 % 72 % 75 % 83 % 79 % 87 % Advisor: Uncertain 28 % 6 % 14 % 16 % 15 % 12 % 14 % 20 % 20 % 22 % 13 % 10 % 10 % 7 % Advisor: Pessimistic 13% 8 % 10 % 13 % 18 % 10 % 9 % 12 % 15 % 6 % 12 % 8 % 11 % 6 % Investor: Optimistic 7 % 36 % 29 % 13 % 9 % 18 % 21 % 11 % 16 % 21 % 32 % 31 % 36 % 30 % Investor: Uncertain 48 % 50 % 52 % 53 % 51 % 53 % 58 % 51 % 51 % 64 % 51 % 53 % 50 % 55 % Investor: Pessimistic 45 % 15 % 19 % 34 % 40 % 28 % 22 % 38 % 33 % 15 % 17 % 16 % 14 % 15 % This chart was created by asking advisors to indicate how optimistic or pessimistic they are about the capital markets looking out over the next three years, on a 5-point scale of extremely pessimistic to extremely optimistic. Then we asked them to gauge the sentiment of their clients on the same scale. Russell Investments // Financial Professional Outlook p / 10

Russell s survey snapshot: tax-aware investment strategies. FIVE KEY TAX-AWARE TAKEAWAYS: 1. Talk to your clients about tax-aware investing. It s the one conversation about government policies that you actually have some control over. 2. Focus on the distributions of the total portfolio, not the rate of return. It s the after-tax performance that matters. 3. Educate yourself on rebalancing strategies and the new tax laws. 4. Reach out to some of your high net-worth clients CPAs and other tax professionals to build your professional network. 5. Learn more about tax-managed investing by reading our blog at HelpingAdvisors.com. Russell Investments // Financial Professional Outlook p / 11

Methodology Russell Investments conducted the Financial Professional Outlook survey between February 27, 2014 and March 7, 2014. The survey was sent to a broad group of U.S. financial advisors. Having a financial relationship with Russell was not part of the criteria for being included in the survey. In total, 173 survey responses were received representing nearly 100 firms. The sample size of 173 is sufficient to provide 95% confidence that the results will be within plus or minus 7.6%. In other words, if we repeated this survey 100 times we would expect to find similar results in 95 of the 100 trials. About Russell Investments Russell Investments provides asset management and investment services to institutional and individual investors. We offer mutual funds, indexes, alternative investments and implementation services such as transition management and trade execution. Russell has offices in most major financial centers and serves clients in more than 40 countries. Russell is one of the world s most influential and trusted providers of investment services. A pioneer in multi-manager investing and the creator of the Russell Indexes, Russell manages over US$259 billion in assets under management* as of March 31, 2014. We work with 580-plus independent distribution partners, ranging from small and midsized organizations to many of the world s largest and most sophisticated investors, responsible for hundreds of billions of dollars. Our innovative investment approach is made available to individuals through a network of strategic distribution alliances and independent investment advisors. Our clients include banks and insurance companies, investment advisors, defined benefit and defined contribution plans, endowments, foundations and sovereign wealth funds. We seek to understand capital markets and identify investment managers we believe have exceptional capabilities. To achieve these goals, our analysts hold thousands of research meetings each year with investment managers around the world. The cumulative knowledge we gain from this in-depth research serves as the foundation for all of our products and services. Founded in 1936, Russell is headquartered in Seattle, Washington. Russell is a subsidiary of Northwestern Mutual, and the company s executive management has a minority equity participation in the firm. More information about Russell s investment products and services is available at www.russell.com. * Includes $74.8 billion of derivative overlay AUM not included prior to June 30, 2013. Russell Investments // Financial Professional Outlook p / 12

General disclosures Russell Financial Professional Outlook is a product of Russell Investments, produced independently of Russell s investment and manager research services. The information contained herein has been obtained from sources that we believe to be reliable, but its accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein result from surveys of persons outside Russell Investments and may not represent the opinion of Russell Investments, its affiliates or subsidiaries. This report is provided for general information only and is not intended to provide specific advice or recommendations for any individual or entity. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. Please note, advisors surveyed do not necessarily use Russell products. Russell 1000 Index: Measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index). Performance quoted represents past performance and should not be viewed as a representation of future results. The Russell logo is a trademark and service mark of Russell Investments. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Financial Services, Inc., member FINRA, part of Russell Investments. Copyright Russell Investments 2014. All rights reserved. First used April 2014 RFS 14-12578 Russell Investments // Financial Professional Outlook p / 13