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Moving the Goal Post

The effects of "inequality solutions” are often felt more harshly by those aspiring to be in the top 1% than by those ensconced at the very top.

Don Phillips, 02/10/2014

Everybody seems to target the wealthy these days; even those in the top 1%, like Warren Buffett, Bill Gross, and much of Hollywood, call for higher taxes and more penalties on wealth creation. The problem is that the effects of these “inequality solutions” are often felt more harshly by those aspiring to be in the top 1% than by those ensconced at the very top. While the problems of the upper-middle class are understandable not top-of-mind in the public debate, they should be to the financial planning profession, as this group of aspiring investors is its primary clientele.

U.S. advisors, of course, are well aware of the numerous tax increases, surcharges, and deduction caps already imposed on their wealthier clients—all of which make accumulating a suitable nest egg for retirement and kids’ college costs more difficult. Now these same clients have to deal with calls to raise taxes on capital gains and dividends to the level of ordinary income. (In practice, these taxes would likely rise above ordinary income for many clients, as the 3.8% Medicare surcharge would apply.) This increase could effectively double the anticipated tax rate for some clients who are shifting from living off their human capital to living off their investment capital as they enter retirement. If enacted, these increases would sharply curtail in retirement funds or postpone by several years the retirement ability of many Americans. With so few people effectively navigating today’s retirement planning landscape, it seems especially cruel to move the goal post on that very segment that has played the game successfully, doing all the things the financial services community has advised—living within their means, saving for the future, and investing for the long run.

Just as Buffett became the poster child for recent tax increases, PIMCO’s Bill Gross may be the figurehead for the next one, having written an editorial in support of such an increase the same week as he announced his intention to give away most of his wealth. Perhaps we’ll hear politicians refer to increased cap-gains taxes as the Gross Principle, the same way they pointed to the Buffet Rule to justify the 2013 tax increases. I don’t question the noble intentions of Buffett or Gross. Both men have made enormous contributions to the investment field and are entitled to share their views. But I do think it should be noted that 1) the increases won’t make a dent in their lifestyles, as both are simply choosing between what goes to charity and the timing of when the rest goes to the government, and 2) both advocate changes that would make their businesses relatively more attractive.

For Buffett, higher taxes make Berkshire Hathaway BRK.B, which has never paid a dividend, a more attractive investment vehicle than any managed fund, as managed funds are required to distribute their income. For Gross, an increase in capital gains and dividend taxes would make bonds, the asset class his firm specializes in, more attractive relative to equities. Interestingly, Gross argues now is the time to equalize investment and wage taxes, implying some other time would have been less appropriate. What’s unique about this moment in time? Bonds at today’s low yields are unlikely to generate capital gains for the foreseeable future, whereas stock funds are beginning to disgorge large gains as tax losses from 2008 have been used up. Similarly, bond interest is today taxed as ordinary income plus the 3.8% surcharge on wealthier clients, whereas stock dividends are taxed at a more favorable rate. The increases Gross proposes would improve the fortunes of asset managers whose business favors bonds. With one regulatory stroke, managing PIMCO over the next decade would become a more attractive prospect. If I were Gross, I’d be tempted to make the same case—he wins points with the public, he enhances his firm’s prospects, and his lifestyle doesn’t change a whit.

In a broader sense, though, asset managers would benefit to a degree from these tax increases, as the increases would force wealthy individuals to amass bigger nest eggs and to maintain them for longer in order to pay the bigger tax bite when they turn to living off their investment assets in retirement. Financial planners whose practices are based on assets under management would similarly benefit. All of which raises an interesting fiduciary question: Will asset management firms and the financial-planning community stand up for what is clearly in the best interests of many of their taxable clients, or will their effort be more restrained knowing a longer stream of future fees will flow their way if these measures pass? Personally, I don’t hold out much hope for this group of successful, but not nearly filthy rich, investors. They’re outflanked, taking hits from both the extremely rich and advocates for those less fortunate. Ain’t too many people singing the Upper Middle-Class Blues these days, but perhaps advisors owe it to their clients to do so.


Don Phillips is a managing director of Morningstar, Inc.

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