(Request) Spreadsheet/Model comparing after tax returns of ETF, Life assurance, Directly held shares, non tax relieved pension contribution?

[Zenith63]

Assuming the purpose of this exercise is to help ordinary people (so not AAM pros) decide which will give them the best chance of a higher after-tax return between investing in an index via an ETF or by buying a basket (say 20) of individual shares from the index, there are two other rows for the spreadsheet that could do with some discussion, I think.

The first is how closely the basket of shares follows the index/ETF. The obvious factor is that you could be unlucky, and a number of your picks could drop and stay down (sectoral issue, geographic issue, etc.), which will tend to have less impact in a 500-1500 constituent index/ETF. Less obvious factors include:

• Not rebalancing frequently enough and becoming overexposed in certain areas.
• Rebalancing too frequently and incurring extra transaction fees.
• Insufficient understanding/research to properly diversify across sectors, geographies, or accurately mimic the index.
• Allowing emotions to trigger a buy in a sector you 'like' (AI/crypto a good example today) or a sell after bad news/languishing (Apple in the 90s, Microsoft in the 00s, Ford in the 2010s).

It is difficult to put a firm number on this, but I presume we all agree it is not 0%? I came across this:

A novel paper by Dyer and Guest (2022) offers several insights on this topic as it examines the tracking ability of 3,365 U.S.-based equity physical ETFs and mutual funds from 2010 through 2020. Among the studied funds, 52% use physical replication, 37% use representative sampling, and the remainder are 'hybrids' that typically employ physical replication but may implement sampling under certain conditions. The study shows that sampling funds have higher turnover and expenses while earning worse returns relative to full replication funds. In particular, the differences in costs and returns translate into about 60 basis points lower returns for samplers per year on a net return basis. This finding is not driven by niche indices, as authors find similar results in the subsample of funds tracking the S&P 500 and other market-cap-based indices.

So perhaps +0.6% return to ETFs would be a good conservative guesstimate given the samplers in this study are pros?


The other factor is the cost of one's time, which is consumed in some of the following ways when not using an ETF:

• Learning is required upfront to figure out the basics of how to diversify stock picks and understand the makeup and behaviour of the index you're trying to replicate.
• The portfolio needs to be assessed, say once a year, and research done to decide if rebalancing is required and if so, how much of which stocks to buy/sell.
• From experience, there is quite a bit of administrative overhead involved in holding 20+ global shares, for example, US W-8BEN foreign investor forms every few years, lodging dividend cheques, documenting dividend withholding taxes, transferring all of this to your accountant every year and answering questions, reading through notifications about splits, rights-issues, delistings and wondering if you'll be impacted.
• An eye will need to be kept on estate planning rules in certain countries usually included in global indices in case they shift out of your favour.
• While perhaps not applicable to AAM pros, the average person will spend a non-zero number of hours worrying about why a stock they chose has gone down, how it impacts them and should they take action, or one going up they overlooked - this will generally occur around 3am-4am in my experience, a time I tend to value highly for sleep.

While one might overlook much of this for a small investment, when it reaches life-changing numbers (which I assume is what we're talking about here), none of it can be avoided. It's just a matter of whether you manage it in 4 hours a year, 10 hours, 20 hours. I'm curious the number others might put on this, but I think 10 hours per year is conservative, so a cost of €500? Instead of adding that as a fixed figure, which will impact smaller portfolios harder it might be better to say something very conservative like 0.35% of the portfolio as you are likely to spend more time the bigger it gets.

 

[3CC]

That's an interesting point @Zenith63 .

I have heard the argument that an ETF will produce better returns and/or lower risk than a basket of shares due to better diversification but I never knew how to estimate the value of that in hard figures.

I have not invested in shares myself but it's a fair point about the time required to manage things. There is an admin overhead for ETFs also but this is only every 8 years and can be reduced substantially if you avoid a drip fed approach to investing.

From my calculations, ETFs would need to return ~ 0.6% pa more to make up for the better tax treatment with shares, which is coincidentally the same as your figure above.

For my own part, I am starting to conclude that:
1. ETFs are taxed more heavily than shares but this might be offset by better performance.
2. There is an admin overhead for both options. I suspect most people will just favour the option that they are already familiar with. Both are manageable if you are organised.
3. There is the annual CGT allowance which favours shares but the value of this is limited (especially for larger investments) and is being eroded each year by inflation .
4. The big distinguishing factor is the fact that CGT is reset on death for shares. So if you plan to leave a large legacy, shares are probably the way to go.
5. If you expect to play lower rate tax when receiving dividends, shares are better.

Like many things, it's not a clear cut thing. For me shares probably come out slightly ahead but I am little put off by the potential additional admin.

 

[Zenith63]

4. The big distinguishing factor is the fact that CGT is reset on death for shares. So if you plan to leave a large legacy, shares are probably the way to go.

There's a previous thread on AAM where it was pointed out that Exit Tax is similarly offset against CAT on death - https://www.askaboutmoney.com/threa...pped-michael-mcgrath-to-review.230266/page-10

 

[ClubMan]

For me, this thread calls to mind a famous John Bogle (founder of The Vanguard Group) quote...

“The greatest enemy of a good plan is the dream of a perfect plan. Stick to the good plan.”

 

[Zenith63]

For me, this thread calls to mind a famous John Bogle (founder of The Vanguard Group) quote...

“The greatest enemy of a good plan is the dream of a perfect plan. Stick to the good plan.”

Agreed, the other issue is that people are spending so much time procrastinating over this decision they’re likely losing more money sitting on the fence than any possible tax savings their eventual decision yields.

The thing is, it’s my view that the advice AAM should be giving the average person walking in off the street asking how to invest their savings is to put it into a single World Equities ETF, without question. Advising people to dabble in share picking is trying to reach tax perfection by what is now clearly a negligible amount when everything is factored in. An ETF is cheap, easy, low stress and simple - a good plan.

 

[ClubMan]

Agreed, the other issue is that people are spending so much time procrastinating over this decision they’re likely losing more money sitting on the fence than any possible tax savings their eventual decision yields.

At the risk of boring people with the same post again, that's exactly what I did for too long...

What to do with a million euros?

Personal details Your age: 49 Your spouse's age: 54 Number and age of children: 2 aged 9 and 14 Income and expenditure Annual gross income from employment or profession: €30,000 (state job) Annual gross income of spouse/partner: €60000 (state job) Pension: have maxed AVC’s (should I also...

www.askaboutmoney.com

The problem is my view is that the advice AAM should be giving the average person walking in off the street asking how to invest their savings is to put it into a single World Equities ETF, without question. Advising people to dabble in share picking is trying to reach tax perfection by what is now clearly a negligible amount when everything is factored in. An ETF is cheap, easy, low stress and simple - a good plan.

I took a slightly different approach but it's worked out pretty well for me. There may have been an even better one, who knows...

As another famous businessman, Tony Soprano, said, "more is lost by indecision than wrong decision".

 

[Zenith63]

At the risk of boring people with the same post again, that's exactly what I did for too long...

What to do with a million euros?

Personal details Your age: 49 Your spouse's age: 54 Number and age of children: 2 aged 9 and 14 Income and expenditure Annual gross income from employment or profession: €30,000 (state job) Annual gross income of spouse/partner: €60000 (state job) Pension: have maxed AVC’s (should I also...

www.askaboutmoney.com

My experience was that I had the benefit of reading your and Brendan's posts recommending buying a basket of shares ~20 years ago. I did that for a decade or so and really enjoyed learning and the ups and downs, hours and hours spent watching the Deepwater Horizon disaster wondering how best to play it with my BP shares, hunting down SCRIP/DRIP shares to maximise compounding etc. It ultimately lead me to start a business using the money I'd invested.

Fast forward 10-15 years I had money to invest in the markets again, but this time decided to go with a single diversified ETF. The experience is utterly different - I spend no time researching companies, no emotional tugs while in that world of researching towards the latest meme stock, no time rifling through stuff like SCRIP receipts and dividend withholding tax slips to get them over to my accountant every year, no time trying to harvest annual CGT allowances, no time lying awake at night wondering if buying Vodafone was a good call or not buying Microsoft will punish me. When I buy I stick the date/price in a Google doc that my accountant can review in nearly a decades time and I look at the price on the index every week or so with interest, that's it.

While I loved the process of learning to buy individual shares I don't think it is for the vast majority of people, and having seen both sides of this I am very firmly of the view that we should be recommending a single ETF to most people off the street that ask for advice on AAM and not a basket of shares. The individual shares approach is in my view letting the tax tail vigorously wag the safe investment dog for the average punter.

 

[ClubMan]

My experience was that I had the benefit of reading your and Brendan's posts recommending buying a basket of shares ~20 years ago. I did that for a decade or so and really enjoyed learning and the ups and downs, hours and hours spent watching the Deepwater Horizon disaster wondering how best to play it with my BP shares, hunting down SCRIP/DRIP shares to maximise compounding etc. It ultimately lead me to start a business using the money I'd invested.

Fast forward 10-15 years I had money to invest in the markets again, but this time decided to go with a single diversified ETF. The experience is utterly different - I spend no time researching companies, no emotional tugs while in that world of researching towards the latest meme stock, no time rifling through stuff like SCRIP receipts and dividend withholding tax slips to get them over to my accountant every year, no time trying to harvest annual CGT allowances, no time lying awake at night wondering if buying Vodafone was a good call or not buying Microsoft will punish me. When I buy I stick the date/price in a Google doc that my accountant can review in nearly a decades time and I look at the price on the index every week or so with interest, that's it.

While I loved the process of learning to buy individual shares I don't think it is for the vast majority of people, and having seen both sides of this I am very firmly of the view that we should be recommending a single ETF to most people off the street that ask for advice on AAM and not a basket of shares. The individual shares approach is in my view letting the tax tail vigorously wag the safe investment dog for the average punter.

Good post - but I'm still happy with my BRK.B et. al. simplified approach to direct equity investment and the preferential and simplified (no dividends) tax treatment. Admittedly it's probably riskier than a more diversified ETF but less so than a manual portfolio/basket of shares approach.

 

[Zenith63]

Good post - but I'm still happy with my BRK.B et. al. simplified approach to direct equity investment and the preferential and simplified (no dividends) tax treatment. Admittedly it's probably riskier than a more diversified ETF but less so than a manual portfolio/basket of shares approach.

I probably should have said that if I was doing it all over again I would go the same route, what I learned was invaluable and as I said I loved it, even the downs. But from talking to friends and family over the years I know the average person is not like this and would much more likely have come out the far end with nothing or a deep distrust of stock market investing.

So my view is that if somebody comes to AAM asking about entrepreneurship, learning how stock markets work and expressing a tolerance for risk then we should direct them to buy a basket of shares. If they come here with their life’s savings in a bank account, no knowledge or interest in stock markets and an aversion to risk we should be recommending an All World ETF and downplay the drama about Deemed Disposal, referring them to the spreadsheets in this thread showing the returns to your pocket and lifestyle are basically the same.

 

[3CC]

For me, this thread calls to mind a famous John Bogle (founder of The Vanguard Group) quote...

“The greatest enemy of a good plan is the dream of a perfect plan. Stick to the good plan.”

Agreed. Both ETFs and shares are good options. Just pick one and go with that. They are both much better than leaving cash on deposit while you mull over the minutiae.

 

[OutlierStudio]

I probably should have said that if I was doing it all over again I would go the same route, what I learned was invaluable and as I said I loved it, even the downs. But from talking to friends and family over the years I know the average person is not like this and would much more likely have come out the far end with nothing or a deep distrust of stock market investing.

So my view is that if somebody comes to AAM asking about entrepreneurship, learning how stock markets work and expressing a tolerance for risk then we should direct them to buy a basket of shares. If they come here with their life’s savings in a bank account, no knowledge or interest in stock markets and an aversion to risk we should be recommending an All World ETF and downplay the drama about Deemed Disposal, referring them to the spreadsheets in this thread showing the returns to your pocket and lifestyle are basically the same.

More than anything, the lack of loss offset is what really grinds my gears.

Picture this.

It's 2007, you just got a windfall of 1 million. "Hurray I can retire now!". You dump it into an ETF and retire, selling off small bits of ETF as your source of income. Then 2008 rolls around and you're down 50% on your ETF. You still have to sell, you're retired after all, every sale is now 50% loss. It's 2012 now, it took 5 years for the ETF to be back to break even of 2007. Since you can't use ETF losses, that's a lot of money you will never ever see again.

Under CGT, you would use those losses against gains after 2012 and be no worse off in the end, but not under ETF tax.

I can understand 41% rate. I can understand deemed disposal.

I don't understand why loss offset are not allowed for funds only, when allowed for Income Tax & Capital Gains Tax.

Could anyone tell me the rationale behind that?

 

[Zenith63]

More than anything, the lack of loss offset is what really grinds my gears.

Picture this.

It's 2007, you just got a windfall of 1 million. "Hurray I can retire now!". You dump it into an ETF and retire, selling off small bits of ETF as your source of income. Then 2008 rolls around and you're down 50% on your ETF. You still have to sell, you're retired after all, every sale is now 50% loss. It's 2012 now, it took 5 years for the ETF to be back to break even of 2007. Since you can't use ETF losses, that's a lot of money you will never ever see again.

Under CGT, you would use those losses against gains after 2012 and be no worse off in the end, but not under ETF tax.

I can understand 41% rate. I can understand deemed disposal.

I don't understand why loss offset are not allowed for funds only, when allowed for Income Tax & Capital Gains Tax.

Could anyone tell me the rationale behind that?

Yes that is a strange one.

But just to be clear, losses within the ETF, which might include 500+ companies, will be offset automatically without being taxed. And through average costing you can effectively offset losses for the same ETF in a given year. What you’re talking about is carrying forward losses in subsequent years, which is indeed a difference from individual shares but is unlikely to be a concern to the vast majority of investors, particularly the ordinary person in the middle of their career investing for 10-20 years.

 

[OutlierStudio]

Yes that is a strange one. But just to be clear, losses within the ETF, which might include 500+ companies, will be offset automatically without being taxed. What you’re talking about is carrying forward losses, which is indeed a difference from individual shares but is unlikely to be a concern to the vast majority of investors.

I'm not quite yet convinced of that.

If you could indefinitely hold shares, then it would be very unlikely to pose a problem. Invest today, never sell and 40 years from now your oldest shares will have gained perhaps 1400%. When next 2008 rolls around, even a 50% drop would mean your oldest shares are still around 700% gain and so can be "safely" sold in retirement without worrying about losses.

However deemed disposal changes that equation. It only gives you 8 years before tax is due. If you're investing non trivial sums, it's highly unlikely that you will be able to cover the tax out of pocket and be essentially forced to sell your oldest most profitable shares to cover the tax. What remains then is the "younger" shares that are less profitable and thus more likely to go from small profit to a loss when next 2008 style 50% drop happens.

This 8 year cycle repeats, perpetually keeping you closer to break even than CGT ever would.

 

[Zenith63]

it's highly unlikely that you will be able to cover the tax out of pocket and be essentially forced to sell your oldest most profitable shares to cover the tax. What remains then is the "younger" shares that are less profitable and thus more likely to go from small profit to a loss when next 2008 style 50% drop happens.

You can use the average cost instead of FIFO which will help here.

 

[SPC100]

@3CC

Major Kudos to you on the updates in your sheet!

When I'm considering this space, one other important option is to contribute more to your pension.

Unfortaunately there are a myriad of varietes there, depending on how much tax rate you pay at what rate, and how much you have already contributed.

For my case, I'm a higher rate tax payer, that is already making the max contibution that one can get tax relief on. I could contribute more, and have it accumulate with no tax drag, but ultimately it would be subject to income tax when I draw it down. (and there are some other risks like the fund threshold). Would you be interested in trying to model this too?

 

[Fortune]

That's an interesting point @Zenith63 .

I have heard the argument that an ETF will produce better returns and/or lower risk than a basket of shares due to better diversification but I never knew how to estimate the value of that in hard figures.

I have not invested in shares myself but it's a fair point about the time required to manage things. There is an admin overhead for ETFs also but this is only every 8 years and can be reduced substantially if you avoid a drip fed approach to investing.

From my calculations, ETFs would need to return ~ 0.6% pa more to make up for the better tax treatment with shares, which is coincidentally the same as your figure above.

For my own part, I am starting to conclude that:
1. ETFs are taxed more heavily than shares but this might be offset by better performance.
2. There is an admin overhead for both options. I suspect most people will just favour the option that they are already familiar with. Both are manageable if you are organised.
3. There is the annual CGT allowance which favours shares but the value of this is limited (especially for larger investments) and is being eroded each year by inflation .
4. The big distinguishing factor is the fact that CGT is reset on death for shares. So if you plan to leave a large legacy, shares are probably the way to go.
5. If you expect to play lower rate tax when receiving dividends, shares are better.

Like many things, it's not a clear cut thing. For me shares probably come out slightly ahead but I am little put off by the potential additional admin.

I'm not quite yet convinced of that.

If you could indefinitely hold shares, then it would be very unlikely to pose a problem. Invest today, never sell and 40 years from now your oldest shares will have gained perhaps 1400%. When next 2008 rolls around, even a 50% drop would mean your oldest shares are still around 700% gain and so can be "safely" sold in retirement without worrying about losses.

However deemed disposal changes that equation. It only gives you 8 years before tax is due. If you're investing non trivial sums, it's highly unlikely that you will be able to cover the tax out of pocket and be essentially forced to sell your oldest most profitable shares to cover the tax. What remains then is the "younger" shares that are less profitable and thus more likely to go from small profit to a loss when next 2008 style 50% drop happens.

This 8 year cycle repeats, perpetually keeping you closer to break even than CGT ever would.

In that case, you would receive a rebate of the deemed exit tax when actually selling at a loss

 

[3CC]

@3CC

Major Kudos to you on the updates in your sheet!

When I'm considering this space, one other important option is to contribute more to your pension.

Unfortaunately there are a myriad of varietes there, depending on how much tax rate you pay at what rate, and how much you have already contributed.

For my case, I'm a higher rate tax payer, that is already making the max contibution that one can get tax relief on. I could contribute more, and have it accumulate with no tax drag, but ultimately it would be subject to income tax when I draw it down. (and there are some other risks like the fund threshold). Would you be interested in trying to model this too?

Hi SPC100.

Thanks an interesting question.

If my figures are correct, investing in your pension in excess of the age related limits, and therefore without tax relief on the way in, does not look great.

My figures are based on paying the higher rate of income tax in retirement on the entire value of the pension other than the 25% tax free lump sum. If you expect to pay the lower rate of tax, the outcome is better at ~€201k rather than ~€158k.

I have assumed that you leave the full amount invested for 16 years. If you retire the pension sooner than that, you will presumably take the 25% lump sum and therefore will have less invested (in a subsequent ARF) which will lower your return.

The pension option becomes more attractive when the benefit of the tax free growth outweighs the fact that you need to pay income tax on both the capital and the growth (excluding the tax free lump sum). For this reason, the pension option might outperform the others over a longer time period.

So my own take from this is that the pension option could be better if you expect to pay lower rate income tax in retirement. Otherwise, probably not unless the investment horizon is very long.

Sometimes I get the sums wrong so I'd appreciate if you let me know of any errors.

 

[SPC100]

Very interesting! Thanks so much for extending your modeling. I wasn't expectin such a clear cut outcome.

Granted, this is sort of the ''worst case pension model scenario': No tax relief, high income tax on drawdown.

I agree with you, that as you extend the time period, the pension scenario should improve.

In real life, I think there may well be much longer time periods. e.g. I would not be drawing down everything in one future year (until i die!), I would be drawing a small amount (or having the imputed distribution) each year. Notionally, I would potentially 'never' actuallly draw down much of the additional investment (or it's growth, beyond imputed distributions), e.g. if you cast it as the last thing you ever withdraw from the pension.

Regardless, would be interesting to see how many more 8 year periods it takes for pension to get ahead.

 

[3CC]

In real life, I think there may well be much longer time periods. e.g. I would not be drawing down everything in one future year (until i die!),

Yes - that's very true. It's probably not worth modelling yearly drawdown but maybe a reasonable approximation would be to assume that your average investment period is half way through your expected retirement. So for example, if you are 55 now and intend to be retired from age 60 to hopefully age 85, then your average investment period will be from age 55 to age 72.5 which 17.5 years.

I have looked at the scenario again but now over a longer period below. This is using a different file but I have set the figures below to be the same as those above for consistency. So the file looks different but the scenario should be identical. (I have used the cells in green to cross check against the figures above.)

The result is that with no tax relief on pension contributions, 25% tax free lump, and higher tax rate on all income at drawdown (assuming you have already used your lower rate tax band with other income) - the tipping point in favour of the pension contributions vs the Accumulating ETF is ~ 24 years.

In truth, you would need to divest the 25% lump sum much earlier than the rest of the funds and so the pension would perform a bit worse than my figures indicate.

If your income tax rate was 20%, the tipping point is about 8 years.

So pension contributions in excess of the age related limit seem beneficial if you expect to be a lower rate taxpayer during retirement. If you expect to be a higher rate taxpayer in retirement, surpassing the age related limits probably only makes sense for those who are younger than say 45-50 years of age.

Hopes this helps.

 

[Ent319]

Fantastic thread. Seems to confirm by evidence what one would expect intuitively.

With the greatest respect to people that do invest in baskets of shares – including those who seem to have done well out of it – it seems very unlikely this would outperform a global equities index fund, even with deemed disposal and a 41% exit tax rate.

If it was easy to get gains above what you can get in an index fund by randomly selecting shares we wouldn't need index funds. I'd love to see some hard numbers from people who've followed the basket of shares strategy, and a comparison of how they might have fared had they invested the same amount in ETFs in the same period.

This would be all the more the case if deemed disposal gets nuked and exit tax goes down to 33% as planned.