Article written by Anthony Edmonds – 17th June 2024

I’ve heard a few times recently where financial advisers have said they don’t take tax into account when making investment recommendations.

I find this really odd.

In designing any portfolio your objective is to provide future funding to pay future liabilities, or in other words, expenses. Given that you can only use after-tax dollars to pay for things, taking tax into account when designing investment portfolios is a must.

Tax can have a massive effect on what you end up taking home.

Tax on direct shares v PIE funds

A common example of where this comes into play is when advisers recommend their clients invest in direct shares and bonds, despite the same core investment exposure being readily available through tax-efficient portfolio investment entity (PIE) managed funds.

A key benefit of PIE funds is the capped tax rate of just 28%. Direct investments into shares and bonds on the other hand are taxed at the investor’s marginal income tax rate – which can be as high as 39%.

The 11% difference in tax rate is hugely significant – even more so when you crunch the numbers and realise that for an investor in direct shares, this equates to a nearly 40% higher tax bill in absolute dollar terms compared to a PIE investor.

But it’s not just those investors in the $180,000+ income bracket that will be pinged at the highest 39% rate. From 1 April 2024, the tax rate on income earned by family trusts jumped from 33% to 39% and is now applicable to income from assets like direct shares and fixed interest securities.

However, if a family trust holds the same sort of investments through a PIE fund, then this same trustee income is taxed at a final rate capped at 28%.

For example, if both direct investments and PIE investments generated a 5% return, a family trust will pay 1.95% of the total value of directly held assets in tax (5% x 39%). On the other hand, the PIE fund’s returns will be taxed at just 28%, for a total tax bill of just 1.40% of its value.

If we apply that to a family trust that starts at $250,000, with a 5% annual return over 20 years, the difference is huge. The trust that invests into PIEs at 28% tax will have an ending balance of $500,000, while the trust that invests in direct investments at 39% tax will have an end balance of $447,000 – $53,000 less.

Recent data published by the IRD suggests that the top 25% of family trusts have significantly higher levels of assets than that, so are likely to benefit from being in managed PIE funds significantly more.

For anyone on a top tax rate, including a family trust with trustee income, not investing in PIE funds is tantamount to simply burning money by paying a higher level of tax.

The better tax outcome is why we are seeing lots of investors switch away from investing directly into shares and fixed interest securities into PIE funds.

Diversification

Most, if not all, people that invest in direct shares and bonds look to diversify their portfolios. However, I’ve never seen anyone with direct investments come close to being as diversified as managed PIE funds are.

Often, people and advisers that create their own fixed interest portfolios hold 15-20 individual securities. Which sounds like a few, but this means that in reality each security represents around 5% of the investor’s total portfolio.

Imagine a bank manager trying to explain to their boss that they lost 5% of the bank’s total assets on a loan to one business. Similarly, imagine finding out that your bank had lent all its money to just 20 businesses.

In reality this is what many investors do when they work with an adviser to create a directly held fixed interest portfolio. Yes, it’s diversified, but the impact of one of those investments falling over is still material.

By comparison, PIE funds like the Hunter Global Fixed Interest Fund hold more than 500 individual fixed interest securities, and a diversified fund like the Foundation Series Growth Fund has exposure to more than two thousand underlying securities.

There’s really no competition in terms of which option is more diversified.

Why would an adviser not recommend managed PIE funds?

Real alarms should ring in a modern world with PIE tax and diversification benefits if you find your portfolio is full of direct shares and fixed interest securities – especially for investors on higher tax rates, including family trusts with trustee income.

Traditional advisers who have recommended this approach typically duck and weave, saying that tax shouldn’t be the primary driver in designing portfolios for clients. But, as with any income, tax ultimately dictates what ends up in your pocket. It absolutely does need to be considered.

If it’s not, it’s more likely that the adviser promoting this approach is getting brokerage and transaction fees through these direct investments – which forms a big part of their take home pay – after tax of course.