With the S&P 500 index approaching double-digit returns for the third year in a row, many investors are likely salivating over their swelling wealth in investment reports. But they should know something about what's not printed in most investor statements: accurate results. That's because investment reporting today is misleading, largely due to out-of-date regulations and a lack of innovation in the wealth management industry. It doesn't have to be this way, though.
New technology now exists for wealth managers to provide a "total wealth return" performance report, or an accounting of the total amount of net wealth they generate for their clients. Think that is what you're already getting today? You probably would not be alone, but you would be wrong.
For that to be the case, the companies that sold you those products would have to deduct the taxes they generated for you while pursuing those gains, which can be as much as a 20 percent haircut off of the tantalizing investment returns you may currently be looking at. In fact, current regulations only require investment companies to deduct fees from those results.
Tax haircuts pile up quickly, though: While inclusive of more income sources than just securities investments, Internal Revenue Service data indicate, for instance, that capital gains accounted for about $125 billion in taxes in a recent tax year.
Using new technology today, investment managers could either use your actual tax rate or an assumption about it to calculate your total wealth return from their decisions. This is a more realistic estimate of their impact on your wealth, since it would deduct the tax expenses created for you by the companies you hired to build your riches.
The benefits of a total wealth return are much broader than just a more accurate accounting of your wealth. The real value in this new reporting standard is that it aligns your incentives as an investor much more tightly with the companies you (or your employer) pay to build wealth for you in investment markets.
What needs to be done to grow your wealth more
A total wealth report pressures investment managers to reckon with the tax implications of their decisions, since each dollar of tax they generate for you would be reduced from their advertised return for investors. This would incentivize them to proactively invest in the steps needed to lower your tax bill, such as by minimizing their trading or employing tax-loss harvesting techniques.
Wealth managers would also be much more motivated to build your actual wealth, not just investment returns. The truth is, advisors and funds alike have lots of potential tools at their disposal to build wealth on your behalf, the effect of which current reporting rules ignore. Advisors, for instance, can use technology today to optimize retirement benefits, withdrawal sequencing orders and estates. Investment funds, too, can use technology today to do a better job of taking into account outside holdings, personalized risk preferences and even health considerations, all factors that can mean the difference between outperformance or underperformance relative to your wealth potential.
"Since the Securities and Exchange Commission forced investment companies to report performance results net of fees, these expenses have fallen precipitously. The same outcome could be expected with the total-wealth-return reporting standard we propose."
The low-fee revolution in investment products is evidence that a total wealth return reporting standard inclusive of tax consequences would lead to improved outcomes for clients. Since the Securities and Exchange Commission forced investment companies to report performance results net of fees, these expenses have fallen precipitously. The same outcome could be expected with the total-wealth-return reporting standard we propose. It would force wealth management companies to compete against how much wealth they build for you, not investment returns, which are just a means to the actual wealth-building end investors all seek.
Fund companies, advisors, custodians and brokerages all have the technology to do what we're proposing. For instance, advisors can use custodian cost-basis data (and their client data) to deduct tax liability from performance results and expectations, as well as quantify the impact of their tax-reduction strategies. Fund companies could also easily sample their customers, use published IRS data or simply a modal example to adjust performance for expected tax liabilities. They can also figure out account withdrawal optimizations. The Vanguard Group released a paper on implications of account withdrawal order for taxable investors but does not do these calculations for individual clients.
Regulators, too, are long overdue for an updating of their performance reporting guidelines, most of which predate the development of the technology that now makes this more robust wealth accounting possible. It seemed for a moment like we were moving closer to this better reporting standard. The DOL fiduciary rule that was killed earlier this year emphasized — both in the rule itself and especially in subsequent guidance — that the "best interest" of the clients should not be narrowly defined in terms of fees and investment returns but should also consider the broader portfolio and life situation of the client. That broader definition of best interest was included at the urging of both consumer advocates and some within the financial industry.
The bottom line is that today the will is not there among financial companies as long as they are not required to be judged by this higher standard. It costs time and money to invest in these wealth-building tools, and that is not money wealth managers are likely to invest if they are being evaluated solely on investment returns instead of the reason investors actually invest money: to build wealth. We expect that it is inevitable that the industry will one day be held to this higher standard, since the technology already exists. But for now, we're not holding our breath.
—By Matt Fellowes, founder and CEO of United Income