Householding: Time to Get Your House in Order

“Householding” means managing multiple accounts to a single goal, leveraging tax-advantaged accounts where possible. The point is not just to manage each account well. It’s to manage the accounts as a whole well.

So far, so good, but you may be wondering what this really means. We’re hearing a lot more about householding recently and thought it might be useful to summarize some of what we’ve learned.

The Elements of Householding

Here’s what it takes to jointly manage a set of accounts:

1. Ensure that the investor has the right portfolio when you combine all the accounts. This is basically the definition of householding.
2. Minimize transaction costs and taxes. This is where advisors can really add value:
1. Avoid selling a security in one account and simultaneously buying it in another
2. Minimize the tax effect of sales by preferentially realizing losses in taxable accounts and gains in tax-advantaged accounts
3. Minimize future taxes by putting assets that generate taxable income in tax-advantaged accounts
3. Obey the rules. Most tax-advantaged accounts have rules limiting how much you can put in or take out. After retirement, there are also rules setting required minimum distributions. Accounts can have different “buy lists” of permitted product and min/max asset class requirements, especially for cash.  

Deep Dive: Minimizing Transaction Costs and Taxes

Obeying the rules (e.g. not violating minimum required distribution rules) can be a challenge, but we don’t see much disagreement about what it means to obey them. However, tax management is another story. While everyone agrees that minimizing transaction costs and taxes is a good thing, there’s a range of opinion about how this should be done. The problem is that different tax minimization strategies can conflict with each other:

• The best way to minimize capital gains is to do most of your rebalancing in a tax-advantaged account. This dictates making sure the tax-advantaged accounts have holdings in every asset class; that is, the tax-advantaged accounts should be a miniature copy of whole.
• On the other hand, the best way to minimize tax on income is to load up tax-advantaged accounts with securities generating interest and short-term gains.

It’s not clear how to reconcile these two strategies. Do you concentrate all your tax-inefficient product in your tax-advantaged accounts or keep a mirror copy of your whole strategy there? And, if you start with a suboptimal distribution, what level of trading costs and taxes are you willing to bear in order to make it better? To get all of this right, you would need to know not only how much income different securities will generate, but also how often you’re going to be trading.

What We See in Practice

We doubt there’s a simple right answer here. In practice, we see managers follow, more or less, a fairly simple set of rules:

• Minimize turnover: In general, if an investor has the right portfolio in aggregate, leave well enough alone, even if asset location is not optimal.
• Minimize capital gains: When it’s necessary to reduce exposure to an asset class, try to do it in the following order:
• Sell losses in taxable accounts
• Sell gains in non-taxable accounts
• Sell gains in taxable accounts
• Minimize future taxes: When there is cash to invest in multiple accounts, either from income or sales, try to buy the most tax-inefficient products, like hedge funds, in tax-deferred accounts.

It’s a strategy that puts a premium on minimizing today’s transaction costs and taxes. In principle, you could do better than this, implementing some sort of multiperiod optimization that actively remixes asset allocations across accounts. In practice, we’re not so sure. There’s a danger of overprecision in trying to perfect this, so simple is good. As physicist Niels Bohr supposedly once said, prediction is difficult, especially about the future.

Growing Demand for Householding Done Right

Jointly managing a household’s accounts is not a new problem, but we’re seeing a rising interest in doing it reliably and well, part of a larger industry trend away from a performance-based value proposition to a value proposition that stresses planning and workmanlike professional execution. With the rise of robo-sites that can handle simple household accounts, there is more reason than ever for advisors to get householding right.

If you’re still struggling with jointly managing the accounts in a household, it’s time to take action. Time, if you will, to get your “house” in order.

For more on this topic, check out The Three Types of Wealth Management Firms.