Asset Location

Some of the most common statements I hear when first discussing wealth strategies or investment planning are:

“My money is with Allan Gray!” or

“Coronation looks after my investments!”

Asset Location as investment decision

These statements are often made with a tremendous sense of pride and satisfaction which is testament to the fantastic job that these companies do marketing themselves. Variations do include Investec and Foord or every now and then one of the up and coming boutique managers who are topping the performance tables over 3 or 5 years.

But the truth of the matter is that not a single asset manager among these offers or is authorised to provide investment advice – That is to say they provide the tools (investment funds) for you but they can’t help you to incorporate those funds into a plan to achieve your objectives.

So the comments about which asset manager you use are actually relatively meaningless and do not convey any information about your strategy and how well placed you are to reach your objectives.

Every now and then the statements may take it one step further and some may mention what their ASSET ALLOCATION might be. Asset Allocation describes the make-up or exposure that your portfolio has to the main asset classes (Cash, Bonds, Shares, Property), and accounts for roughly 80% of the returns that your portfolio will generate over time. It is also the broad measure that many balanced funds use to intimate or imply risk – A 70% equity market allocation is termed high equity and considered risky, whereas a 40% equity allocation is considered low equity and moderate risk for example.

But almost no one talks about the concept of ASSET LOCATION, even though they will in fact implicitly be making these decisions every time they invest.

“Asset location” refers to the type of account or investment vehicle that you use to invest your assets. You can hold the same asset allocation structure discussed above, often using the exact same funds, in different types of investment accounts. The main differences  between the different types of accounts available to individual investors hinge on the tax treatment of returns (income and capital gains) within those accounts.

SARS (The South African Revenue Services) provides incentives to individuals to encourage them to save for the long-term by offering tax breaks and benefits if investors subscribe to certain types of investment vehicles.

Asset Location is therefore a very important consideration when structuring your long-term investment strategy because you can hold the same funds (Asset Manager and Asset Allocation) within different vehicles BUT have significantly different real return profiles over the long-term. Below you will hopefully find some useful information to familiarise yourself with the concept of Asset Location and how to potentially think about incorporating it into your strategy.

What are the key types of account available to individuals?

The majority of this difference in performance is the result of the tax treatment of each vehicle or type of account. The main differences between the tax treatments are illustrated in the following table:

Tax treatment of Asset Location

Which type of vehicle or account is best?

All things equal the tax deferred option is likely to give you the best real returns because contributions are made from pre-tax income and your assets get to grow tax free until the time at which you want to draw an income. So SARS essentially contributes towards these accounts by allowing you to deduct what you put in here before paying the tax man.

For you to contribute towards a normal direct discretionary investment account you pay tax first on your income and then you get to invest your savings from what is left over.  The same applies to the newly launched tax free accounts.

This means that if your effective tax rate is 30%, your portfolio’s starting value is 30% larger if you use a tax deferred account (Pension, RA, provident funds) relative to the other two.

Even when you consider that your income in a tax deferred account is taxable when you withdraw it, the compounding effect of the additional boost in initial capital will likely offset this over a long period of time in the majority of cases.

Of course the extent to which these benefits are realised depend on each individuals marginal and effective tax rates at contribution stage and retirement stage. With tax deferred contributions any amounts in excess of the annual limits can be offset against future tax liabilities at the income drawdown stage which further complicates calculations or modelling.

What are the practical considerations when incorporating Asset Location decisions into your wealth strategy?

Generally speaking contributing to a tax deferred account up to the maximum contribution limits and then putting excess towards the tax free savings option is probably the best strategy to follow for the majority of individuals. Any additional investments over and above these limits can be invested in direct discretionary accounts. (Note that excess contributions to retirement funds can be deducted from income at the withdrawal stage).

Having your capital growth assets (Equities/Shares/Stocks) in direct discretionary accounts over the long-term makes sense as you will incur the lowest tax rates for dividend income and capital gains tax relative to the marginal tax rates on your interest or rental income options. 

For example: If your portfolio structure is 60% equity, 15% listed property, 25% cash and bonds you may well do best to have your income producing assets like property, bonds and cash in the tax free and tax deferred accounts, while leaving your long-term holdings in equities invested in your direct discretionary investment accounts. (Of course this would all be subject to limitations of other regulations such as Regulation 28 which governs exposures within retirement savings funds).

Since tax free savings accounts have a life time limit (R500, 000 currently) and a R30,000 annual allowance, there are limits to your ability to freely choose between which type of vehicles to use. To reap the rewards of the tax benefits within a TFSA you should only consider using them for true long terms savings (Retirement and beyond) rather than for any short term objectives.

Retirement funds have restrictions (or they are in the process of being introduced) that prohibit the withdrawal of funds allocated to these vehicles. For example current contributions to a Retirement Annuity cannot be touched until you are at least 55 years old. I do not think this is a bad thing as cashing in pension contributions each time one move jobs is one of the largest contributing factors leading to poor financial outcomes at retirement for most individuals. Retirement funds also have limits on the asset allocation parameters which can be used according to legislation in Reg 28 – you can only invest up to 75% in equities for example.

If you have found this useful but have some questions or if you would like to find out more about how to incorporate Asset Location decisions into your personal wealth strategy please get hold of us using the following contact details.