Note: Descriptions are shown in the official language in which they were submitted.
CA 02309853 2001-04-03
FIELD
The present invention rdates to a method/system for selecting for an investor
an appropriate
risk/returdtax efficient allocation of a plurality of seeds to a portfolio
divided bdweea taxable
and taxrsheltered investment accounts and for the display of such optimal
allocation graphically
or dphanumaieally, simultaneously across taxable and tax-sheltered accounts.
BACKGROUND
Investors constructing portfolios of assets inside their taxable and/or
sheloered account(s),
consisting of mutual funds, stocks, bonds, T'-bills or other of numerous
various asset classes
typically seek to maximiu the expected or mean rate of return of the overall
portfolio for a given
level of risk or volatility" froque~ly defmod in terms of variance of return
and based either on
historical data or projected cxpxtod rates of return utilizing techniques
known to persons skilled
in portfolio management or economic modeling.
Utilizing Markowitz's classical mesa-variance ef~~cieatt frontia or Sharpe's
inclusion of the risk-
froe asset in the mean-variance model, or any othea suitable risk/reward
optimization technique
by those experienced in the field of asset allocation and subsequent
generation of the eflycient
frontier or a matrix of riskheturrt values, an appropriate optitaizad
investment portfolio can be
selected offering the highest rcturn/reward for a given level of
risk/volatility suitable for an
investor of a particular risk tolerance level.
Classical modern portfolio theory (MP'I~ and other sophisticated asset
allocation models are
ecadeanic models based oa tax-free iavestmaut rates of return. In fact, one of
the underlying
assn~tions of MPT is the absence of tax. "Chase useful and powerful theories
arc utilinod and
applied to the practical world in the management of ime~nent portfolios with
the objective of
maxianizing return and minimizing risk of invesmtent portfolios designed for
the investor's
individual return objectives sad tolerances for portfolio risk or volatility.
From a practical standpoint investment portfolios are immediately or
ultimately subject to tax (in
most cases, undo most taxation regimes), whether the investment assets are
held in taxable
accounts or in tax-sheltered accounts. Not only this, but certain investment
assets are taxed more
favourably than others. In the field of finance iavestmertts that are taxed at
lower rates and/or
taxed only upon disposition, are rofa~rod to as tax-advantaged while those
taxed at highs rates
and/or when they generate income are refarod to as tax-disadvaatagod.
Contributing to the
effective tax-adva~age or disadvantage of t particular investment asset that
usually has to be
coasidaod, in practice, its the timing of the taxation of investment assets.
For example, sn equity
asset can usually grow in value indefinitely and not be subject to tax until
it is disposed of, while
interest income Gem interest bearing investments is genaally taxed annually,
at unfavourable tax
rates. The interest-bearing asset can only be prevented form generating
taxable income on a
regular basis by being placed into a tax-sheltered plea. 'The equity asset may
be tax-advantaged
therefore for two reasons: 1. A Lower taxation rate, and 2. An innate
sheltering from tax thus
allowing a tax,free compounding of its market value.
Tax-disadvantaged investments ere therefore usually best held in tax-sheltered
investrnent
accounts where the ~rnings can compound rather than sensate innmodiarte taxes
that reduce the
funds available for re-investment.
Astute investors will find that even invesmxats or investment income that are
taxed at favourable
rates, for axmmplo marl-bonds (in the US) or prafeaed shares (in Canada)
should oftat be bald
2
CA 02309853 2001-04-03
inside tax-sheltered accounts as opposed to inside taxable accounts, to
prevent loss of the
potential compound ea<uings on the annual taxes snood.
Since a tax-advantaged investment tray not be perfectly tax-efficient over
very long investment
holding periods, say over 40 years, it may on lain occasions be favourable to
hold tax-
disadvantaged investments outside tax-sheltered plans to replace the tax-
advantaged invas~ents
usually held outside. The compound growth of the "not perfectly" tax-et~cient
tax-advantaged
investm~ent(s) held inside the aht1lerect account and an equal amount of the
tax-disadvantaged
investmeat(s) held in the taxable account, owes time may exceed the growth-
after tax- of the tax-
advantagod investments) being held in taxable accounts end the equal amount of
tax-
dissdvarnaged investments) held in a sheltezed account. Over very long periods
of time the
compound growth of the taxes saved on an ineffcient tax-advamagad investmem
may supercode
its innate tax advantage.
In most situations tax-advamaged investments such as stocks or equity mutual
funds, or
exchaa~go-traded fords are sufficiently tax-e~ciec~t and tax-advantaged when
cxtmparod to tax-
dissdvantggod investments such as ea~tiueates of deposit to allow an investor
to makc the geareral
assumption that tax-disadvantaged investments should be held in sheltered
accounts and tax-
sdvant:aged outside.
In this taoc-e~ieat optimization system a trst for tnu long-term tax-
~ei~ciency of each
investment in comparison to each other investment, although not essential,
should be condrrctod
to ensure appropriate assignment to taxable or sheltered account.
For the above reasons one can see that them is a wide gap betwe~ acsdernic
tiraozyr and itc
advanced risk/reward optimization techniques and the practical minimization of
an invest~'s
takes. This gulf has not boon broached despite practical application of
sophisticated asset
allocation memodolog~ies to institutional and individual investment
portfolios. 'Ihe present state of
the art is focussed and centred on the generation of optimal investment
portfolios that match
investor risk tolerance, but that do not account for altar-tax investiment
rdurns.Usually asset
allocation portfolios npr~nting ranges of risk/return optimizations are
frequently categorized as
"low," "medium," or "high" risk portfolios suitable for "conservative",
"modorata" and
"aggressive" investors. These allocation recommendations are applied to both
taxable and tax-
shaltered investm~t accounts in an identical fashion, with ao inclusion ofy or
refs to, the tax
implications of those recommendations, nor are suitable adjustments made to
reduce tax on the
overall portfolio. Investors may not even ovntemplate, nar have a~ control
over the tax
implications of the particdar asset allocstiaa investrneat product that they
are purchasing such as
an asset allocation mutual fund or a balanced mutual firad (which is also an
asset allocation fund),
since the fund will be invested as is, in either a taxable or tax-sheltered
account, or both, once
again without a~ reference to tax, yr the ability to make adjustments to
reduce overall tax.
Some advisors provide model portfolios rew:ommavded for taxable and tax-
sheltered accounts.
However, the inves~nent allocations for bath taxable and tax-sheltered
accounts, given an
investor's cisk/retarn optimization era invariably identical. Even in the
situation where an advisor
differentiates between taxable and tax-sheltered portfolios to adjust for
after-tax returns in the
taxable portfolio, the recommendations for either portfolio are performed in
isolation, and do not
attempt to simultaneously allocate across all accounts. The division between
taxable and t$x-
shelterod accounts in the investor's overall portfolio needs to be considered
in conjunction with
the risk/reward optimization before the alkxations can be apportioned to
minimize tax aaoss the
overall portfolio and not just on one side ofthe overall portfolio, i.e. the
taxable side.
3
CA 02309853 2001-04-03
Another deficaertcy in the present practice off asset aDocation is the
racommardation of portfolios
that are tax-effici~t, g~erally by way of a'"hands-on" dent of appropriate
assets to
applicable taxable or tax-sheltered accounts by the financial advise, leading
to an overall
portfolio that is tax-efficient but that lacks risk-reward optimization.
Assignment of assets to
portfolios is generally accomplished through financial advisors while
optimization of inve~ment
assds is usually the domain of academics. Thus, advisors seddng both tax-
e~ciency and
risk/rcward efficiarcy, do not have a formal process enabling them to optimize
portfolios vis-~
vis risk, return and tax.
The present invention addresses these difficulties by providing a system that
combines academic
portfolio theory with practical tax planning. In addition, the print process
incorporates another
fimdarnental principal in finaact, namely, the time value of money. As stated
in the claims, the
tax-efficiency of the overall sheltered and taxable accounts is taken ova a
number of periods, the
fixed investment period, automatically accounting for the effects of
compounding rtturas.
Traditioosl asset allocation models not only allow tax disadvantaged
investments to be plead in
taxable accounts without consideration of potential placement of thox
investments to tax-
sheltered accounts, btit they do not consider the potential compounding
earnings that could be
made if those taxes paid on the tax-disadvantaged investments were tax
sheltered.
Tax shehered and taacable portfolio management covers but is not limited to
the following types
of investment strategies and investmeart acranunts: cash or invcstiment
accounts, pension plans
including RRSPs, RRIFs, RESPs, invesunont componau of universal life insurance
policies. The
asset allocation decision in terms of today's state of the art tends to
allocate solely for the
particular accoum that is under consideration, for example an R.RSP account,
or a RRIF account,
or for a taxable brokerage account. ion with nefor~ce to risk/rehun for the
risk
tolerance of the investor is most likely achieved, but the tax implications
are unfortunately
ignored due to the construction of either the asset allocation program or dre
product itself. For
exatnpley bala<rced mutual fiends do not easily facilitate practical tax
minimization. A balanced
mutual fiend cannot be split so thpt the interest bearing investments can be
naosferred to the tax-
shelterod plan, while the equity investments; arc transferred to the taxable
plan.
Ia fact, one could go so far as to say that with the present stato-of-the~art
only invGStors solely
holding tax-sheltered investment accounts, containing assets prodwcizrg income
and withdrawals
trued equally for tax proposes do not naedl to be concerned about the tax-
et~cieocy. Those
investors owning any inveatmeuts held outsade tax-sheltered pl~rs and
employing say state of the
art asset allocation system or model will most likely pay more tax than need
be gives a particular
level of risk tolerance. Spxifically they mast likely will bo paying tax on
their interest bearing
investments at a higher rate and fitquency »haa on lower tax rate equity
investments taxed only
on dispositiarr. Factors not accomrted for in traditional risk/reward
optimizations.
Another defici~cy one notes with the prestxrt practice of asset allocation is
in the preseattation of
suitable asset rocommeudations for investors. The standard format, whether the
media be
brochures, computer software or proBraats, models displayed on web-sites, or
other mediums of
display or computation, is to prat pie charts or similar mesas of visual or
alphanumeric display
detailing suitable wtighting of asset clasxs or investment mix, either for
each of an investor's
taxable and tax-sheltered accounts; or to supply present a "suitable" mix or
allocation of
investment assess for the investor's complete portfolio, without consideration
of the magnitude of
the two types of accounts. Investment xlecxion for the investor's accounts
then takes place
through selection of one or more of these "!model" portfolios, or of
investments representing these
models. Unfortunately for the reasons mentioned earlier in this text these
recommendations are,
most probably, not tax-efficient, except in the one case of an investor
holding only a tsx-sheltered
4
CA 02309853 2001-04-03
account Another observation that should be~ noted is that even in the
situation of an investor
solely holding a taxable account the rocomnxndcd asset allocation is most
likely not optimal
since carefid comparison of the advisor's rccommendod taxable and tax-
sheltered accounts
invariably illustrates identical allocations for both. Therefore, the
recommended portfolio most
likely will not lie on the efficient frontier du~c to the different aRcx-tax
return of the investments
held in a taxable account versus a tax-sh~teTed one. In addition, most likely
it will n~ provide
effective tax-minimization.
The present inv~tion provides not only a system to provide risk/rewardltax
efficient portfolios,
but an effective means of display; neither of which has been addressed by
existing asset
allocation models.
SUI~IARY OF THE INVENTION
The present invention is a system, method and/or process to date and display
investment
portfolios for investors that arc rish/return and tax efficient. In other
words, the objective is to
assign and display weightings of various investinents, representing selected
asset classes, to
portfolios that maximize return ova time fir a given level of risk, while
simultaneously
minimizing taxes vn the investor's overall pottfolio-whether it cotapeisos
taxable, sheltered, or
both taxable and sheltered accounts. The systan, process and method can
utilize forms, coa~tputer
programs or hardware, the Internet (World Wide Web) or other ~titable mediums
through which
the system, method and~or process can bo implemented, utilized and displayed
Data is imputed representing rates of rorurc~ of selected investrnant assets,
then modern portfolio
theory and/or other techniques employed by dtose txperienced in the investment
management
field are used to generate an efficient frontier or array of portfolios
representing the highest
expo~dlprojecxsd redvms for given risk loveLs. Based on the risk tolerance
levels of various
investors "ideal" matching lane-sheltered pcHtfolios consisting of the
appropriate mix of the
investment assets are produced. These "ideal" portfolios provide the template
from which the
suitable overall ascot allocation for both ts;Kablc and sheltered portfolios
will take place.
After-tax rattan data representing rates of mtmn of the same selected
investment assets is
imputed. The investor's lima frame and dre exact tax treatment of the returns
wiU affad the atta-
tax tines of return. MPT and/or other tochruques employed by those experienced
in the
investment management Geld is/are used two generate an efficient frontier or
array of portfolios
representing the highest expxtod/potentiall returns for given risk levels.
Based on risk tolaance
levels of various investors' ideal matching taxable portfolios consisting of
the appropriate mix of
the investment assets arc produced.
Prior to assignment of investment assets to taxable and sheltered accounts in
accordance with the
investor's optimal asset mixes for taxable and sheltered portfolios, the
weighting of these
rospoarve accounts to the investor's overall portfolio is calculated. The size
of the investor's
shehuod scoount in relation to the investor's overall portfolio, and the ratio
of the tax-
disadvantaged assets in the "ideal" portfolio plax a constraint on the
assignment of tax-
disadvaataged assets to the tax-sheltered portfolio. Prior to assignment, as
applicable, of the tax-
disadva~ged ascots, a test of the tsx-effi~aency of the tax-advantaged assets
is wade. Based on
the investor's time frame and the tax-efficiency of the inveshuent(s) over
that time Frame, a
comparison between the rntu<n of the invrsOment inside a tax-sheltered plan
and ~tside is made.
This is done to account for the chance that even a tax-advantaged investment
may do worse
outside a teat-sheltered plan if the loss of growth on the taxes paid on the
tax-advantaged
CA 02309853 2001-Oa-03
invesanent(s) over the investor's time p~io<i exceeds the highs-taxed growth
inside. In most
cases this will not be the case. In the situation that it is, however, the tax-
sdvantaga3 investment
will be assigned on a priority basis to the tar; sheltered plan.
In the most common assigamont, that of the tax-disadvantaga3 invastcnent(s) to
the tax-sheltered
account, the ratio of the tsx-disadvantaged invesmiont(s), calculata3 earlier
in the ideal portfolio
(a value between zero and one), is subtracta3 from the weighting of the tax-
sheltered account to
the investor's overall portfolio (a value between zero and one). If the
re~ltant is positive, the full
value of the tax-disadvantaged investment is assigned to the tax-sheltered
account and the
shortfall of content in the tax-sheltered plan is provided by assignment of
the tax-advantaged
investment. If the result~t is negative, in other words there is an excess of
the teat-disadvantaged
assets that cannot be assigned to the tax-sholtend account, it is necessary
for them to be assigned
to the taxable account employing the results, for the optimal taxable account.
This is achieved by
multiplying the ratio of the excess tax-disadvantaga3 investments) to the size
of the taxable
account with the ratio of the tax-disadvantgga3 investments) to tax-adva~agod
investments)
selected firom the after-teat array of portfolicrs. The balance of the taxable
account will consist of
the tax-advamaged investment(s).
Once the optimal allocations have boon asa;rtainod, the present invention
provides a technique of
display for rive investors, either in chart or alphanumeric form, of bodt
their recommended
taxable and tax-sheltecod/deferred account, that automatically imbeds the most
effodive
investrneat/asset assignment from a taxation standpoint.
It is accordingly an object of the present inv~tion to overcome the
limitations of the known art
and to provide an asset allocation mdhod that accounts for the tax
implications of tax-
advantagod, tax-disadvantaged investments, both inside and out of taxable and
shelbetbd
(deferred) invesmnent portfolios.
It further is an object of this invention to sunuhanoously display for both
investor's taxable and
tax-sheltered accounts, either Graphically rnr alphanumerically, charts that
effectively "imbed"
tax~fficieacy into a risk/roturrt opa~ZOn for investors of varying risk
tolerances (and timo-
horizons).
It further is an object ofthis invention to provide and/or display
tax/risk/return efficient portfolios
for investors who solely own taxable or tax:-sheltered (deferred) accounts.
It further is an object of this invention to provide a systom/process of
op~mizstion for all ascot
classes and investment accotsat types. These investment accounts could
iactude, but would not be
restricted to, RRSPs/RRIFs, RESPs, univwsal life insurance, and other tax
shelters.
It further is an intention of this invention to provide graphical display of
taxable and tax-shelteeed
accounts that provides comparative sizing of the investor's respective
accourrts. For example, if
the investor has equally sized taxable and Isx-sheltered accounts the
simultaneously displayed
aocoums would be of equal size. If the imostor has a teat-sheltered account
that is twice as large
as his taxable account the size of graphical representation of the tax-
sheltered account will be
twice the size of the taxable account.
It is, however, not an intention of this invention to be restricted by this
method of displgy. Equal
sized charts representing taxable and sheltered accounts, even if they are not
of equal monerety
size, may be desired. This will in no way c;ffea the essential nature of the
charts to imbai tax-
efFcioncy into risk/reward efficient portfolio displays.
6
CA 02369853 2001-04-03
GLOSSARY OF TERMS
Asset - refrrs to an investment, usually classified as either cash, bond(debt)
or equity (stock)
Exempt - refers to an investment or account that avoids tax completely. An
txarnple could be the
investment account of a life insurance policy that grows without taxation and
pays out tax-Gee
upon death of the insured
Investment- refers to property in which money is invested, can include assets
such as cash, bonds,
equities, mutual funds, pooled funds, end other managed money accounts
Investor - any person, partnership, corporation or any entity committing mosey
to an investment
portfolio.
Managed money - any poanfolio of moray that is professionally managed and
invested - includes
products and services such as mutual funds, unit trusts, wrap accounts, pooled
funds, pension
fiends.
MPT - abbreviation for modern portfolio theory.
Sheltered investment/account- any investment or account that tends to defer,
shelter, redacx or
eliminate tax.
Note that the word sheltered and tmc-sheltered have the same meaning
throughout this application
Taxable account - refers to an account that offers no means of tax sheltering
to the invesaaants
held within it, although some of those investments may have their own innate
tax-sheltering
ability.
Tax-sdva~ged investments - are generally those that have an i~te ability to
defer tax, or are
taxed at prefearatial rules. The most common type of tax-advantaged investmem
would be an
equity or oamrron stock. However it is possible for every tax-advantaged
investments to have tax-
dissdvanmgod income, such as dividends.
Tax~i~advsatagod iavestmarts - are gea~rally those that do not have an ability
to defer tax,
andlor are taxed at highs tax rates. Bonds generally pay internal that is
taxable, in most regimes,
armually at high rates, with little or no possibility of deferral.
Tax-efEcaoncy - a moasun of the ability of an investment or account to
ma~cirniu after-tax
rehrm. The more tax-efficient it is the higher the aver-tax rettnn.
Tax-shelter - refers to the ability for an itrvestment strategy or investment
to defer, shelter,
reduce or eliminate tax. RRSPs, RR>Fs. IRAs and 401Ks are examples of tax
shelters. An
extreme, but never-the-less important tax-shelter would be an exempt
investment such as the
investment side of an universal lifo-insurancc policy that shelters earnings
growth and pays out
tax-exempt.
CA 02309853 2001-OG-03
DIAGRAMS
Brief description of diagrams
FIG. 1 depicts the prior art method for displaying recommended "model" taxable
(cash/investment accounts) and tax-sheltered accounts (registerod/t~c-exempt)
or p«tfolios
FIG. 2 depicts simuitana~usly optimized risk/retum/t~c efficient taxable and
tax-sheltered
accounts
FIG. 3 is a flow chart of the system, method and process used to arrive at the
optimized
investment poctfotio(s)
FIG. 4 depicts two aheraative visual displays of tax-eflzci~t asset allocation
models
DETAILED DESCRIPTION OF A PREFERRED EMBODIMENT
The foregoing features of the invention will be more readily understood with
refaencx to the
following ddailod description taken with the accompa~ing diagrams.
The present invention is a systan, process and/or method for optimizing fram a
risk/rdurn
perspective an inveswr's more investment portfolio whether it be invested in
tax-sheltered,
taxable, or auy mixhue of these two types of accounts. Additionally the
procedure could be used
to tax-efficiently assign assets to sheltued/~9afertod and taxable accounts on
a stand-alone basis
without reference to modern portfolio thorny or other commonly utilized
techniques of portfolio
optunizatiion or rislc/rtward management. In traditional asset allocation
modois, the assignmcut of
selecxed invesdme~ asset is often indicated through display of particular
investrnent account,
usually taxable, aheitercd, or neither. FIG I shows some typical "models". 10,
30 and 50 show
conservative, moderate and aggressive m«lels for taxable pisos (accounts). 20,
40, 60 show
conservative, moderate and aggn:asive m«leis for tax-sheltered/deferred plans
(accounts). 70, 80
and 90 show conservative, moderate and alrgressive models without
consideration of type of plan
or account. These models, although perhaps risklnwvard etficitut is a worid
without taxation, in
no way consider the after-tax returns of the, various investment assets in
their assignment to
taxable and shdtered/deferred accounts, rcsuiting in overall portfolios that
are not tax-efficient.
FIG. 2, 100 and 110 (oogether~ 120 sad 130 (together), 140 and 150 (together)
show
simultaneously optimized risk/rawdtmc-e~cient taxable and aheltered/defc~rod
accounts for
conservative, moderate and aggressive investors r~peaively. 160 shows a
traditional asset
alMc~tioa for en investor (of moderate risr: toleranx level) with only a
taxable account. 170
shows a tax-efficient allocation for the same investor. (hots the inexease in
weighting of equity,
tax-advmrtaged, assets and decrease in weighting of cashlbonds due to the
higher after-tax r~ehmt
of the equity aliocation versus 160). 180 slhows traditional asset allocation
for a moderate investor
with only she)taed/delierrod accounts. For that same investor 190 shows a tax-
efficient allocation.
There is no difference in percentage allocF~tion in this case, as there is no
opporhinity for this
investor to preferentially allocate some of his tax-advantaged investments to
taxable accounts.
Note that in these diagxems the magnitude of the various accounts is not
signi6od.
The first step of any asset allocation proce~durc is an assessment of the
investors' 200 profile, 210
in FIG 3. The investor" with hisJher individual and unique respective
investment profile answers
CA 02309853 2001-04-03
questions to ascertain en appropriate mix of investment assets. This is done
through electronic
means (computer. latemct), paper-based questionnaire or other appropriate
means 220. Based on
the investor's risk tokrau~e sad tax situation an appropriate assignment of
investm~t assets will
be made. Before this stage is reached, the tax-efficiency of the potential
investrncnt assets that the
investor will select from must be detaTnirtal.
In most circumstances it is fairly clear and obvious as to which investments
can be classified as
tax-advantaged and which cam be tax~dissdvantaged. For example stocks, are
generally tax-
advantagad investm~ts, and bonds are usually classified as tax-disadvantaged
investments.
However, ova time, and due to what is commonly called "tax-inef6tciency" it is
possible for
stocks to become less tax-efficient than bonds, and to be better held inside a
tax-sheltered
account. To ensure that tinder any circumstances the comet labeling of the
selected investment
assets as other tax-advantaged or disadvantaged dte following methodology can
be used, 230:
1) For the fixed investment period a calculation of the total after-tax
portfolio return where the
"tax-advantaged" investm~t is held in a taxable account and an equal value of
the "tax-
disadvantaged" investment asset is held inside a sheltered account is made.
II) The same
calculation, switching both investment assets to the odxr account is made.
The portfolio with the highest return represents the appropriate priority of
assignment of
investment assets to type of account. It may also indicate a necessary
reclassification of the
foruur "~c-advantaged" investment to thm~ of "tax-disadvantaged" investment
sad vice-versa
Suitabk formulae for steps I and II to facilitate prioritization of investment
asset assignment are:
[1* (1 + R,,~T - (1*(ACB~T)T -ACH~T))'~1 + [(1* ((1 + RB)T - ACB~))' (1-~I
11. [I* (1 + RAT - (1*(ACB~)T ..ACBaT))*~) + [(1* (U + RAT - ACB~T))* (1-~1
Wh~e:
R" _ (annual) rehun on "hoc advantaged" investment inside tax-
sheltered aca~ount
RN _ (amroal) aRer-tax return (in taxable account) of "tax-
advantaged" investmem
Ra = (annual) beforo-tax return (in sheltered account) of tax-
disadvantaged investment
R~ _ (annual) after-tan return (in taxable aocouut) of tax-
disadvaraaged investment
ACBaT = adjusted cost base of "taac-disadvantaged" investm~t at
time T
ACB~T = ad)ustod Cost base Of "tax-advantaged" investment et
time T
M= investota' applicable tax rate at time T
T= investor's time horizon
Note: the initial value for both invcstmeat A & B is assumed to be 1
and each investment initially has no unrealized capital gains
Note: after this prioritization the asset found to be best assigned to
the sheltered account will be called the taoc-disadvantaged asset and the
asset found to be best
assigned to the taxable aCCOUm the tax-advantaged asset.
CA 02309853 2001-O4-03
Using dais of the before-tax rates of return, 240 characterizing the universe
of assets considered
to comprise a portfolio as e~cient frontier or matrix of risk/rtward optimized
assets is generated.
This genantion of the etl~cient frontier is in accordance with one of the
underlying assumptions
of MPT, namely, no taxes.
A second efficient frontier or matrix of riskJreward optimized assets is
generated using MPT or
other technique of risk/reward optimization utilized by those sltilled in the
art, this limo factoring
in the adjusted rates of return for the universe of assets on an after-tax
rate of return, 240. The
calculation of the after-tax return should matdc the investor's time frame.
For example, the after-
tax rates of return of tax-advantaged and tart-disadvantaged investments will
vary with the tax-
advantagod becoming more favourable over a longer period of time due to the
increased potential
of growth of the taxes defaced. An equity asset can grow in value and not
attract taxes on its
increase in capital until :it is disposed o!; while an interest bearing asset
usually forces an investor
to pay annual tax on the interest Taxes paid on the interest bearing assets
are funds that cannot be
utilized for future growth.
Baaod on a particular investor's risk tolerance level and investment time
horizon a suitable
portfolio is selected from the first efficient :&ornier or optinaizod matrix.
This selearon represents
the ideal rislc/reward optimization in the unreal world of no taxation. From
this point on the
preforred embodiment of this invention is essentially adjusting this "ideal"
to fit the real world
where tax~ion plays a vital mle in influencing the best allocation of
investment assets across as
investor's taxable and shdtared accounts. laasad on what a particular
investor's risk tolerance
level and investment time horizon a suitable portfolio is selected from the
second ei~cient
frontier or opmnized matrix. The asset mix and yield for this aptimal
portfolio will differ from
the first d~ to the difference in tax treatmcat of the different asset
classes.
In the instance first an investor has ortly taxable or sheltered account(s),
he/she will move dirxtty
to the respective taxable aptimizabon 280 and sheltered optimization 270
suitably displayed, 250
and 260, respectively.
The allocation to concurrently best fit the assets to both sheltered and
taxable accounts for the
situation of the investor with both sheltered/defecred and taxable accounts
takes place, moving
first to 270 and then to 280 in Fig.3.
The following algorithms, or other mesas derived by a person slcillod is the
art, are used to
ascertain the weighting of invents to the investor's tax sheltered and taxabk
accounts as
indicated in 270 end 280:
T= tJ(t+s) and S= s/(t+s), where T= proportion of taxable account with respect
to hiaJher entire
portfolio
S= proportion of sheltered acoou~ with respect to hislher entire
portfolio
t= value of taxable account
s= value of sheltered accoum
Tax disadvantaged assets are first assigned to the tax-sheltered accounts;
excess tax-
dissdva~aged investments are then assigned to the unsheltered account
according to the
following processlformulae:
if S .d, they d,=1 & a, _ 0 & dc= (d-S~T'(da,d) & a< = ( 1- d~)
CA 02309859 2001-04-03
Wht1'e:
a, = weighting of tax-advantaged assets in sheltered accounts
at= weighting of tax-advantaged needs in taxable account
d=weighting of tax-disadvantaged assets Gem step b in claim
1,4,7,10,13
d,= weighting; of tax-disadvsatagod assets in sheliexed account
d~ = weighting; of tax-disadventagod assets in taxable
accou~s
tier= weighting; of tax-disadvantaged assets in after-tax
optimizaticm from step d in claim 1,4,7, 10,13
In the situation where weighting of the tax ~disadvantagod investment (s) from
step b in claim 1
(4,7,10,13) is equal to or less than the prop~~rtion of the tax-sheltered
account with respect to the
entire portfolio, the tax-advantaged investaaeats will be assigned to the
balance of the tax-
sheltered account and the entire taxable account according to the following
process and formulae.
if S2d, then d;-d/S & a,=(1-d,) 8c a,= 18c d, = 0
The resultant optimized taxable and defarexi accounts are than displayed
either graphically or
alph~erically 290. For a pmrdicular risk tokrance level and ratio of taxable
to tax-shclteced
accounts sad after using the aforementioned methodology, or other technique
derived by those
sldllod in the art, the resultant portfolio (s) are concurrently displayed is
a graphical foa~mat such
as a pie chart representing the assignment of the assets to both the accounts
as shown in Fig. 2. In
the event that the imestor(s) has/have only one account (ie taxable or
sheltered) suitable
optimizations, for a given risk level, will be displayed only for taxable or
sheltered accoums.
Those stalled in the art will appreciate that there are many methods for
suitably displaying the
resultant portfolios.
The nsultemt portfolios can consist of assignment of combinations of invest
assets (mutual
fiends, pooled fiends, wraps, segregated fiends end individual investment
assets), 300, as optimized
above, to match investor investment objective, or could consist of a series of
pro-existing tax-
eff dent optimal portfolios inconded to mapch a wide range of various investor
objectives. Much
in the same way that countless financial institutions have set up series of
faced "model portfolios"
of funds to madch a wide range of investor profiles, a series of tax-etlicieat
model portfolios
utilizing this methodology and aneompassing investors' ahelterod and/or
taxable accounts could
be arranged.
To typify with an example, say an investor has a portfolio consisting of a
sheltered account of
5150,000 and a taxable account of 2200,0(10, has a moderate risk tolerance
indicating a preferred
bench mark asset allocation consisting of a mix of 10% cash, 20% bonds(debt)
and 70% equity,
to produce the greatest return for a given risk level. Traditional asset
allocation models would
usually assign asset weightings of 0.10 cash, 0.20 bonds and 0.70 equity to
each of his accounts.
In dollar terms this translates into 515,000, 530,000, 5105,000, of cash,
bonds, equity respectively
for his sheltered account and 520,000, 540,000 and S 140,000 of cash, bonds,
equity respectively
for his taxabk accou~.
Using the afottmeationod tax-efbciaut optimization method/prn~sslsystem and
assuming this
investor was determiaod, using MPT or other rislc/reward optimization
technique, to have an
optimal "iishJreward" sheltered account consisting of weighting mix of
0.10/0.20!0.70
11
CA 02309853 2001-04-03
(cash/bond/oquity) and as optimal risk/reward taxable account weighting mix of
0.08J0.16/0.76,
then the optimal risk/reward/tax efficient portfolio using the methodology and
algorithms above,
would consist of a weighting mix of 0.23/0.47/0.30 (cas6/boud/equity) to his
sheltered accmmt
and 0/0/1 (cash/bo~d/oquity) to his taxable account. These results in dollar
terms would translate
into a sheltec~od account of S34,SOO170,300/45,000 (eash/bondlequity) and a
taxable account of
5200,000 equity
The disclosed method for optimizing investment portfolios may be implemented
as a computer
progrs~m pmduct or as a paper-based work shoot or through other appropriate
means, for example
over the Internet, to produce the resultant portfolio in a merino suitable to
be utilized by an end
user.
The implementation may include, but not be restricted to a series of computer
instructions fixed
either on a hard-drive or server or a mediocre such as a diskette, CD-ROM,
(ROM or fixed disk)
A preferred ~bodiment of the present inmention includes the visual or
alphanumeric display of
the o~imized taxable and tax-shelbered/dal:emed prntfolios (as applicable),
Fig 4. 310 and 320
(together) show tax-efficiem optimization without indecatiag magnitude of
taxable and sheltered
accounts, while 330 and 340 (together) show magnitude of accounts.
Unlike traditional asset allocation models that do not consider taxation, and
therefore display
recommratdations that are only risklreward efficicat, this present invention
not only provides a
solution to the investor's quest for a risk/roward efficient portfolio, it
illustrates, either graphically
or alpha-numericdly, the appropriate risk/r~ewardltax e~cient recommendations
simultmm~ously
across all investment accounts (as applicable). T'ho recommended asset
ailoc~tion effectively
imbeds tax-etbciency into the recommended asset allocation. Additionally, this
imbedded tax-
eflaciency is not only with respect to either sheltered or taocable accounts
but, simultaneously
across all accounts.
The principal features end advantages aro thus apparent from the steps in the
above flow charts
over the present systan of asset allocation pertaining to taxable and
ahelterod accounts, and thus,
it is intended that all such ~urcs and advantages of the instant invention
fall within the true
spirit and scope ofthe pit invention far optimizing investors' investments in
risk/reward/tax_
efficient portfolios across taxable and ahelt:ered accounts, a process with
unique, novel and
creative attributes. ModiBcetions and variations will readily occur to those
skilled in the art, and
it is not the intention of the present invention to be limited to the exact
constntction and operation
as illustrated and described herein.
12
