Householding unlocks valuable tax and risk perks
Is householding the "holy grail" of wealth management?
“Householding is all about getting clients a better deal,” an executive at a large, multi-family office told me, “…and helping us scale.”
“According to Cerulli, 22% of wealth managers said consolidating to a unified managed household (UMH) is a significant priority, with half reporting it as a moderate priority for their firm moving forward.”
Jerry Michael at Smartleaf, which builds householding software and also offers a managed service through a sub-adviser, SAM, says householding gives wealth managers a compelling argument to bring held-away assets under their roof and a way to rebalance holistically and quickly, while optimizing near and long-term tax concerns.
Despite the benefits, however, householding hasn’t gone mainstream yet.
“We’ve been talking about this for twenty-plus years,” a technology executive complained (with a hint of exasperation) to me at the Technology Tools for Tomorrow conference in Dallas last week, “…the marketplace is still figuring it out.”
What is householding?
Householding is the joint management of every household account.
It doesn’t matter what’s in the accounts (ETFs, direct indexing portfolios, tax-aware long/short strategies, farmland, oil & gas partnerships, etc.). What matters is that they are all managed together.
There are two major parts:
Household accounts
Joint management
Household accounts generally include taxable, tax-advantaged, and tax-exempt accounts owned by families possibly across generations. It may also include irrevocable trusts treated as separate taxpayers, charitable giving accounts, taxpayers may influence, like donor-advised funds, held-away private assets, and more.
Joint management means considering how actions in an account may impact others, while aiming for some goal. It usually involves mean-variance optimization, factoring in each taxpayer's circumstances and constraints.
A readily-available example is preventing wash sales across spouses’ accounts. Another example is minimizing tax while hitting risk targets as investors withdraw cash for consumption.
Unified Managed Accounts (UMA), developed in the late 1990s, is generally considered the predecessor to householding.
Householding unlocks valuable tax and risk perks. This usually means realizing less capital gains, and deferring ordinary income, while hitting household risk targets.
How does householding limit tax?
These are the householding tax features I have in mind:
Asset location (limits income and capital gains tax)
Location rebalancing (limits capital gains tax)
Holistic rebalancing (limits capital gains tax)
Withdrawal optimization (limits capital gains tax)
While I’m interested in the tax stuff, most folks adopt householding for that plus:
Automation (optimizing fast and regularly)
Standardization (a codified, scalable process)
Personalization (handling many taxpayers, and capital gains budgeting)
That's the punch list of things I'm looking for in a householding implementation. But this varies by practice, sub-adviser, and SaaS vendor.
All seem to evolve through stages of householding development. Each stage unlocks some tax and risk perks. The stages are something like the following:
Little household awareness beyond basic visibility into held-away assets, and no coordination across accounts.
Prevent wash sales across household accounts (helps defer capital gains). This may seem obvious to my readership, and table stakes for UMA, but tax-aware rebalancing isn’t universal. The work may happen in spreadsheets, possibly with macros (i.e. proto-automation).
Household reporting and manual management of individual accounts across an entire household. A sales executive told me that some wealth managers don’t care to go beyond this stage. Household visibility is “good enough” for some.
Household risk targeting and joint optimization (we’re squarely in automation/SaaS territory now) that may enable capabilities like asset location and location rebalancing (more below). This possibly includes bespoke treatment for each taxpayer (see “The divorce case” below). Withdrawal optimization is standard at this stage. These tactics defer ordinary income and capital gains realization.
Asset location is part of routine rebalancing, and more customization levers are available, including household capital gains budgets.
The point of this list is to suggest that more zooming out means more tax and risk opportunities.
Quick aside: The divorce case
I’ve heard this case enough times to warrant this short description. Suppose spouses are well aware of (and appreciate) the perks of householding. They may, nonetheless, request equal risk exposure in their individual accounts just in case they get divorced. An executive said that “householding is all well and good until warring spouses wonder why one spouse is holding all the high-growth stocks while the other is stuck with municipal bonds.” Some householding software/managers accommodate this use case.
As of this writing, automated asset location and gains budgeting are the frontier of householding.
Asset location has a couple components worth unpacking.
Household asset location
“The crux of the UMH is asset location, algorithmically determining the best place to allocate client assets.”
Asset location includes two tax strategies…
1) Put the assets in the accounts with the most favorable tax treatment
This often means putting income-generating products, like bonds or derivative income ETFs, into tax-advantaged accounts, hyper-growth funds into tax-exempt accounts, and index funds and municipal bonds into taxable accounts. There’s more to it (see the reading above), but that’s the gist. The result tends to be more income and capital gains deferral.
Parti Pris, founded by Art Lutschaunig and Joe Smith, incorporates location into their daily rebalancing process, usually meaning cash deployment and sourcing.
2) Location rebalancing
Location rebalancing is a portfolio construction technique that aims to make future rebalancing possible using only tax-advantaged/exempt portfolios.
Suppose portfolio management software suggests putting some direct equity exposure in tax-exempt accounts, and with household-level risk in mind we notice an overweight sector partly held in the tax-exempt accounts. In that case, we could rebalance household-level risk using just the tax-exempt account, thus deferring capital gains realization.
If rebalancing isn’t entirely possible using tax-exempt and tax-advantaged accounts, rebalancing continues using gains realization in taxable accounts.
“…there is at least some tension between supporting tax-free rebalancing (= minimizing tax on capital gains) and optimal asset location (=minimizing tax on income),” Jerry Michael at Smartleaf cautioned.
In other words, if we put rebalancing assets like growth stocks in a tax-advantaged account, that limits the amount of income-producing products we can put in those accounts. This means advisers need to be thoughtful about their client, their need for income, horizon, etc. Nonetheless, location rebalancing probably wouldn’t be possible unless the household was managed holistically.
Holistic rebalancing
Household risk management often begins by setting targets, like 60/40 stocks/bonds, at the household level, and then transitioning the portfolio to that state over time.
[aside: Of course, it's never this easy, and some practices resist the notion of household targets, favoring individual account targets.]
Without householding, this usually means doing some optimization/rebalancing at the account level and then fiddling around in a spreadsheet until the household roughly approximates the household targets, or possibly rerunning the optimization with the household in mind. And maybe doing either a couple of times a year. Infrequency often means drift. Multiple optimization processes usually mean trading redundancy (i.e., more, perhaps unnecessary, capital gains realization).
Household rebalancing does all of this in one step.
In some implementations, household rebalancing is a daily thing. Household risk targets, individual taxpayer specifics, asset location, location rebalancing, tax-loss harvesting, holding period management, etc. (i.e. all the usual tax tricks) happen routinely, and, crucially, in a single, joint optimization process, as if all assets were held in a single account (respecting taxation of various account types and taxpayers).
Joint optimization should produce results that minimize capital gains realization while striving for optimal risk targets. In other words, each trade can kill two birds (risk and tax) with one stone using all household assets.
Withdrawal patterns
When clients need cash, it usually means liquidating assets. Optimizing the outcome depends on the household circumstances. Some examples…
MSCI quantified this effect in their recent case study Managing Taxes Holistically May Improve Tax Efficiency. They found that “…a holistic approach could have saved a hypothetical wealth-management client an additional 1.3% in U.S. tax liability associated with a requested cash withdrawal.”
The intuition is that siloed portfolio management optimizes locally. In other words, each sub-account manager independently minimizes tax liability within their accounts. However, that coordinated action, including netting gains and losses across accounts to minimize tax impact and possibly improve risk, results in less capital gains realization.
The holy grail?
Many wealth managers do some version of householding. The process may be ad hoc, infrequent and sub-optimal, and that’s the opportunity vendors are smelling. They want to automate and optimize because that’s what advisers do manually and because it gets results.
Householding improves risk and tax management chiefly through asset location and tax-aware rebalancing. The concrete tax result is usually more income, and capital gains taxes are deferred.
Obsession
Kyle Boddy, founder of Driveline, is famous in professional baseball for his ability to train elite athletes. He was the subject of The MVP Machine, a book about the post-Moneyball era which assumes that players are not static creatures, but can develop through deliberate practice. He’s been at it since 2009.
A few days ago, he sent the following tweet and it struck a nerve. “Late night tech work…” (he often posts about working late), “…intern openings available for those who fit the mold.”
Is the mold obsession?
“Your obsessions are a clue to your earliest vision for yourself,” Arnold Schwarzenegger wrote in Be Useful, a self-help guide.
I'm obsessed with this tax stuff. I think about it constantly. I'm always looking for the latest thing, a new angle, a practitioner use case, etc.
“The obsessed frequently endure,” wrote David Foster Wallace in Infinite Jest (p. 646).
Can the non-obsessed keep up with the obsessed? I don’t see how.
Reminder to self…
Art: Monkey User
Here’s what’s coming up…
