Welcome back to the second installment of our three-part series, in which we’re tackling one of the thorniest questions of all: How does asset location really work?
In Part 1, we covered several key concepts about asset location, and why I recommended most DIY investors simply use a single asset allocation ETF to hold the same asset allocation across all account types.
That’s what Asset Location Light is good for. However, what if “good enough” isn’t enough for you? Today, I’ll show you how to take the expected after-tax return of your portfolio to ludicrously mind-bending levels by implementing a traditional asset location strategy.
Asset Location Light, Revisited
First, let’s take a moment to review the three key concepts we covered in Part 1. You’ll need them to make sense of the next steps.
- Your RRSP is a lot like a TFSA: The taxable, government portion of your RRSP never really accrues to you, the investor. Nor does any growth on this amount. It’s all simply along for the investment ride. Accordingly, the after-tax portion of your RRSP acts more like a TFSA.
- Your RRSP allocations aren’t what you think they are: If you prioritize stocks in your RRSP, this will make your portfolio’s after-tax asset allocation more conservative. Because, after-tax, you end up with less invested in stocks than you might think. If you prioritize bonds in your RRSP, this will make your portfolio’s after-tax asset allocation more aggressive. Because, after-tax, you end up with less invested in bonds than you might think.
- What looks like asset location is often asset allocation in disguise: It’s your portfolio’s after-tax asset allocation (not your before-tax asset mix) that drives your future after-tax portfolio returns.
As covered in Part 1, this all speaks to why it’s fine to use Asset Location Light, with one-ticket asset allocation ETFs across all account types. It’s also by far the easiest way to set up your portfolio.
Setting the Ludicrous Stage
Now that you’ve conquered Asset Location Light, let’s look at a ludicrous level of asset location, so you can consider whether it’s worth your while.
In the following illustrations, we’ll use the single-fund, Asset Location Light approach as our benchmark for all comparisons, with the Vanguard Balanced ETF Portfolio (or VBAL) as our holding. VBAL allocates 60% of its portfolio to stocks, and 40% to bonds.
For our Ludicrous Asset Location strategy, we’ll follow the traditional asset location advice of holding stocks in the following order:
- TFSA first
- Non-registered accounts next
- Corporate non-registered accounts (if you have any)
- RRSP last
Remember from Part 1, holding stocks in your RRSP last will make your after-tax asset allocation inherently more aggressive, which will in turn increase the expected after-tax return of your portfolio. It’s important to note this is no free lunch. Even though you may not realize it, you are taking more equity risk from an after-tax perspective, so the higher expected after-tax return of this strategy is your compensation for taking on this additional risk.
A Ludicrous Asset Location in Action
Enough preamble. Let’s build out both our Light (benchmark) and Ludicrous portfolios.
First, we’ll create a 3-ETF clone of VBAL, by separating its underlying stock and bond components:
- To proxy VBAL’s stock allocation, we’ll hold the Vanguard All-Equity ETF Portfolio (VEQT).
- To proxy VBAL’s bond allocation, we’ll hold a combination of the Vanguard Canadian Aggregate Bond Index ETF (VAB) and the Vanguard Global Aggregate Bond Index ETF (CAD-hedged) (VGAB).
By combining these three ETFs in the correct weights, we’ll have identical exposure to VBAL, but more flexibility, so we can locate our individual stock and bond ETFs in different accounts.
For both our Light and Ludicrous asset location strategies, our total before-tax portfolio value will be $1 million, split as follows:
- TFSA: $100,000
- Non-Registered Account: $500,000
- RRSP: $400,000
Since our before-tax target asset allocation is 60% stocks and 40% bonds, we’ll want to allocate our $1 million as follows:
- Stocks: $600,000
- Bonds: $400,000
For the Light benchmark, we’ll automatically be invested in the same 60% stock, 40% bond mix in each account:
- TFSA: $60,000 stocks, $40,000 bonds
- Non-registered accounts: $300,000 stocks, $200,000 bonds
- RRSP: $240,000 stocks, $160,000 bonds
For our Ludicrous asset location strategy, well locate our 60% stock, 40% bond mix as follows:
- TFSA: $100,000 stocks
- Non-registered accounts: $500,000 stocks
- RRSP: $400,000 bonds
Ludicrous Asset Location: Adjusting for the Government’s Take
So far, so good. But, as we learned in Part 1, the taxable portion of your RRSP, and any growth on this amount, is effectively owned by the government. So, if we assume a 50% effective tax rate on RRSP withdrawals, the $400,000 before-tax RRSPs are actually only worth $200,000 after-tax.
What happens if we adjust our asset class figures to account for this? We’ll find our total portfolio value is only worth $800,000 from an after-tax perspective. This doesn’t impact the after-tax asset allocation of our Asset Location Light strategy. It remains at 60% stocks and 40% bonds.
But it makes our Ludicrous strategy more aggressive, with stocks now making up $600,000 of an $800,000 after-tax portfolio. That translates to a 75% stock, 25% bond asset mix after-tax.
As we now know, a higher after-tax allocation to stocks is expected to result in higher after-tax returns, but this is by no means guaranteed. This assumes stocks outperform bonds over your unique investment timeframe. Especially given the higher expected risks, this isn’t a sure bet.
Light vs. Ludicrous Before-Tax Outcomes
Let’s forget we know anything about after-tax asset allocation for a moment. As far as a naïve investor is concerned, both portfolios are the same, even though their asset location strategies differ. From a before-tax perspective, both portfolios should earn the same rate of return, as their underlying investment strategies are the same.
To put this to the test, let’s assume stocks return 6% and bonds return 2% over the next year, with no rebalancing in either portfolio. At the end of the year, our stocks have increased from $600,000 to $636,000, and our bonds have increased from $400,000 to $408,000. From a total portfolio perspective, both strategies would have yielded the same before-tax portfolio value of $1,044,000 and before-tax annual return of 4.4%. Investors in either strategy would be indifferent between the two strategies.
But, again, that’s before we consider taxes.
One year later … before-tax
Light vs. Ludicrous After-Tax Outcomes
Now let’s pay all taxes owing to the government, including the taxes we’ll eventually owe on the RRSP. We’ll assume a 50% effective tax rate on all taxable income. We’ll also assume stocks have a fully taxable dividend yield of 2%, and the remaining 4% of the stock return will be taxed as a capital gain with a 50% inclusion rate. The 2% bond return will also be fully taxable as income, along with the entire market value of the RRSP on deregistration.
After paying all taxes owed at the end of our one-year period, we find Ludicrous outperformed Light by 0.35% after-tax. But as we already know from Part 1, this outperformance is explained by the portfolio’s riskier after-tax asset allocation, not by its asset location. That is, the before-tax 60% stock, 40% bond asset mix was actually a riskier after-tax asset allocation of 75% stocks, 25% bonds.
One year later … after-tax
Ludicrous Asset Location: An Advantageous Sleight of Hand?
So, you now know how to implement a traditional asset location strategy to increase the future expected after-tax return of your portfolio.
From a behavioral standpoint, this more complicated, Ludicrous strategy has its benefits. If you don’t overthink it, the portfolio remains a 60% stock, 40% bond portfolio on paper. Your account statements and performance reports would reflect the same, as they are all reported before-tax.
Now that you’ve read this post, you know you’re actually tricking your brain into thinking you’re increasing your expected return with what seems like no added risk. Even though the added risk remains (if well-hidden), you may still want to take this approach. There are so few times when irrational behaviour can benefit an investor; this seems like it could be one of those times.
That said, there are also disadvantages to ditching your single asset allocation ETF.
Disadvantages of a Ludicrous Asset Location Strategy
- It’s more complicated. Even though a three-ETF portfolio may seem simple, nothing beats a single asset allocation ETF in terms of DIY simplicity.
- You will be taking more after-tax equity risk. It may not feel like it, but you’re sharing less of the portfolio risk load with the government, relative to holding the same asset mix across all accounts.
- You’ll need to rebalance your portfolio. Any time you add to or withdraw from the portfolio, you will need to review all the accounts in your spreadsheet and determine which trades to place (on a consolidated-portfolio rather than an account-by-account basis). Vanguard rebalances their asset allocation ETFs whenever an underlying asset class becomes 2% over or under its target. This means you’ll need to be extremely diligent with your rebalancing thresholds if you want to closely track the returns of a comparable, single asset allocation ETF before-taxes. For example, VBAL returned 10.20% during the 2020 calendar year. If you failed to rebalance your multi-ETF portfolio during 2020, you would have realized only 9.65%.
- Your accounts will perform differently from one another. During bull markets, you might wonder why your bond-heavy RRSP is doing so poorly. During bear markets, you might wonder why your TFSA and taxable accounts are underperforming your RRSP. In other words, if tracking-error regret might throw you off-course, you may want to stick with the more benchmark-hugging Light strategy.
- You might incur more taxable capital gains. If you can’t keep your portfolio in balance by injecting new cash into it when needed, you may need to instead rebalance periodically by selling equities in your taxable account, realizing capital gains in the process.
Putting Asset Location to Work for You by Going Plaid
If the disadvantages of a Ludicrous location strategy don’t intimidate you, it could make sense for your portfolio. Or, in a final, Part 3 of our asset location series, we’ll look at one more take on asset location. Sure, you can expect to earn higher returns by tricking yourself into taking on higher, after-tax market risks. But what if you want to pursue higher returns specifically from your asset location actions? For that, we’ll need to move past Ludicrous, into a Plaid asset location strategy. Look for that post soon.
RE untaxed portion of RRSPs never accrue to the investor. Should not a stock’s capital gains in a taxable account also be treated in the same manner? The current capital gain of a stock should be discounted for the tax due when the gain is realized. If this was done, it would decrease the percent of capital investment (stocks) relative to other investments in a portfolio.
@Les – Yes, this is mentioned at the end of Part 3 of the series.
I wrote this over on YouTube a couple days ago, but for some reason my comment doesn’t appear, so I figured I’d repost here. As it happens, it seems like some of my thoughts overlap with retail investor’s comment from yesterday.
–snip–
I have to admit, I’m struggling with this one. Ok, fair enough, it’s called the ludicrous strategy, and that’s a pretty apt name, because the argument here is more of a psychological hack than a rational investment strategy. My biggest objection with the analysis here is that it intentionally ignores rebalancing in the portfolio return calculation, but of course that’s not realistic (and you even say that rebalancing is more complicated in the pros/cons section later, because of course we’ll need to rebalance).
The historical conventional wisdom has been to locate fixed income in RRSP because the RRSP is fully taxable at withdrawal, and I still see this advice repeated in contemporary articles (as it is in this video), but I think without fail the numbers backing that advice fail to adjust for after-tax allocations *and* rebalancing. All due credit here that you’re underlining the lack of after-tax adjustment and calling it what it is — a brain hack to trick you into taking more risk — but I’d have expected to see the analysis include rebalancing.
Some time ago I ran a scenario comparing fixed income vs equities between TFSA and a taxable account. (I picked a TFSA because it behaves like an RRSP when you view the RRSP from after tax dollars, a point which you beautifully explain at 1:00 — and thank you for explaining it in those terms, as I find a lot of people struggle with taxation in RRSP and end up making erroneous financial decisions as a result.) In my case I used relatively similar assumptions on the equity side as you did — 2.5% dividend yield, 4.5% return from capital gains, 48% marginal tax rate, 50% cap gains inclusion rate, 31.5% dividend tax rate (i.e. eligible dividends) — but also took into account annual rebalancing with a $9.95 commission fee (not exactly material but easy to include in the calculations), and a 0.09% MER on the equities. With these numbers, over a 15 year time period, I found that the break even point in terms of after-tax returns from both accounts was fixed income yielding 5.5%: above that, it made sense to keep fixed income in a sheltered account, and below that, it makes sense to keep equities in the sheltered accounts.
Seeing as we haven’t seen those sorts of yields from Canadian bonds in over 15 years, with no apparent end to the low yields in sight, the guidance to keep fixed income in sheltered accounts seems rather outmoded to me. I would *love* to see this sort of analysis from someone actually competent (i.e. not me) in the upcoming Plaid video. :)
Thanks Justin!
@Jason – Thank you for your comments! I didn’t include rebalancing costs, as they weren’t necessary to explain the tax concepts. However, from real-life scenarios I’ve run in the past, rebalancing the portfolio would be expected to decrease the benefits of this strategy, due to the higher expected taxable capital gains (unless you could use new cash to top-up underweight asset classes when necessary).
The Plaid video should be out early next year, which might be more up your alley :)
I completely disagree with your opening position …. “Holding stocks in your RRSP last will make your after-tax asset allocation inherently more aggressive, which will in turn increase the expected after-tax return of your portfolio. It’s important to note this is no free lunch. Even though you may not realize it, you are taking more equity risk from an after-tax perspective, so the higher expected after-tax return of this strategy is your compensation for taking on this additional risk.”
Your chosen AA determines your risk. It will produce the same outcomes with the same risk and same %return regardless of which asset is held in which account. You simple decide the %, then you do the math correctly (discounting the RRSP balance by the expected withdrawal tax rate). You can test this by modelling $100 with a 50/50 AA inside a TFSA … calculating its value after x years.
Then put half the after-tax $50 in an RRSP (gross it up to before tax $) invested in one asset. Invest the other $50 in the TFSA in the other asset … calculate its value after x years. Add the after-tax value of both accounts. It will always equal what you modelled for the TFSA only.
When you locate the high risk/return asset inside the RRSP, any $ losses you see on your broker statement will ‘seem’ larger because the account also holds/ invests the government’s money alongside your own … magnifies the $$ losses during a downturn.
The way to deal with that illusion is … Wherever it is that you add together all your account totals, subtract from that total the % of the RRSP that is the government’s money. Note down the net value. Use that net value to compare over time and to calculate rates of return. This controls how your head processes the illusion of larger losses.
It is not necessary except during market crashes. The rest of the time you are fine with the illusion of earning more $ than you actually are.
@retail investor – You’re taking the comment out of context (it is describing an investor who is unaware of the concepts of after-tax asset allocation). For anyone who watched Part 1 of the video, the comment makes perfect sense (they also already understand all your additional comments about the 50/50 AA inside a TFSA vs. RRSP, as similar scenarios were used for the examples in Part 1).
I do, however, like your suggestion about writing the after-tax value on your account statements to focus on the true value of your portfolio (if you’re planning to manage your asset location from an after-tax perspective).
Thanks for these videos, you’re tackling issues that I’ve been trying to wrap my head around for a while and your perspective is enlightening. Can you comment about why you chose to do your location of stocks starting with TFSA first and unregistered second? I would have thought that the higher taxes from bonds and their interest-as-income would mean that we would prefer to have them in the tax-sheltered accounts while equities should be preferred in the unregistered accounts due to the lower tax rate of capital gains.
What makes the TFSA a priority over the RRSP? What makes it a priority over the margin account?
Thanks!
@Adrian – In a TFSA, you never pay tax on capital gains or dividend income earned on the stocks (with the exception of foreign withholding tax). In a non-registered account, you pay taxes on the dividend income each year and the taxable capital gains when you sell.
As we’ll learn in the next episode, to be truly tax-efficient, you technically want to hold stocks in your RRSP and TFSA first (and your non-registered accounts last), while controlling for your after-tax asset allocation.