Comment letter to Proposed Rule on Disclosure of Mutual Fund After-Tax Returns
To: Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 5th Street, N.W., Washington, D.C. 20549-0609 (email: email@example.com)
From: James R. Jones, Assistant to the President, First Investors Management Company, 581 Main Street, Woodbridge, New Jersey, 07095 (email: firstname.lastname@example.org)
Summary of Comments
We believe the proposed disclosure rule is seriously flawed. Obviously, funds which want to advertise themselves as tax efficient should be required to produce the complicated after-tax calculations contemplated by the proposal. However, to impose this requirement on other funds would place a burden on them that is grossly disproportionate to the perceived benefits.
First, the disclosure would not be relevant to approximately half of all shareholders. At least half of all non-money-market fund assets are held in tax deferred accounts. After-tax returns are meaningless at best, and misleading at worst, to this class of shareholders.
Second, even for investors in taxable accounts, the proposed rule is likely to be confusing and potentially misleading. Unlike absolute returns, which are the same for everyone, after-tax returns vary for each investor based upon his or her individual tax situation. Many if not most investors would simply accept the proposed standardized after-tax return figures as being appropriate standards to evaluate a fund for them without taking into account their own tax situations. This will lead to bad investment decisions.
Third, bond funds as a group, and tax exempt bond funds especially, have not caused the type of "problem" that would justify after-tax return disclosure. To our knowledge, bond fund investors have not been surprised by the taxes associated with their investments. This is because the primary component of a bond fund's return is interest income, which is either taxable or tax exempt depending on the type of fund. If you adopt the proposed disclosure rule, bond funds should be excluded. Tax exempt bond funds, in particular, would provide virtually no beneficial disclosure under the proposed rule.
As an alternative to the proposal, we advocate disclosure of a fund's historical distributions and the portions of a fund's NAV attributable to both realized and unrealized capital gains. This would provide the necessary tax information to all investors, regardless of their tax bracket, without risk that they will be confused into making inappropriate or foolish decisions. It would allow an apples-to-apples comparison between mutual funds for those investors interested in both historical and potential future tax effects.
I. Tax-Deferred Accounts
In Section I of the Proposal the SEC recognizes that approximately half of non-money-market assets are held in taxable accounts. Therefore, the other half is held in tax-deferred accounts, for which after-tax returns would be useless. Moreover, as proposed, the after-tax return information would overwhelm the other information in the risk/return summary. Divining the correct return to use among the forest of after-tax and before-tax returns proposed would be an additional burden to investors in tax-deferred accounts and would unacceptably increase the likelihood of their making an error.
II. Taxable Accounts
As the SEC recognizes, unlike absolute returns, which are the same for everyone, after-tax returns vary for each investor depending upon his or her individual tax situation. Thus, whether an investor would be better off investing in a fund that is managed to reduce taxes or one that is managed to produce the maximum possible absolute return is a complicated issue. The attempt to provide investors with standardized after-tax return figures will only confuse and mislead them. Many if not most investors will simply accept the figures as being appropriate for them, without attempting to understand the assumptions that are being made and their relevance. Indeed, many investors probably do not even know their marginal tax rates.
Moreover, the proposed disclosure might inadvertently lead many investors to conclude that mutual funds as a class are not good investment vehicles in taxable accounts, given the current tax treatment of mutual funds. This would be an unfortunate result. Mutual fund investors are typically small investors who lack the knowledge, research time, and capital necessary to invest efficiently in individual securities. The service mutual funds provide to these investors is in pooling capital and providing expert investment management. The proposed after-tax disclosure would overstate the tax advantages of investing in individual securities, which may have the effect of inducing unsophisticated mutual fund investors to consider this alternative. ICI data shows that the median mutual fund investor has only $25,000 invested. This level of capital is insufficient to craft a diversified portfolio of individual stocks. So an emphasis on the tax advantages of individual securities would be detrimental not only to the mutual fund industry, but also to these individual investors.
Section II(F)(1) of the Proposal discusses the tax bracket at which calculations should be made, and draws the conclusion that the simplest and least confusing method is to use the maximum possible rate. Unfortunately, the highest rate applies to less than 1% of the population in general and of mutual fund investors in particular, thus providing misleading information to the vast majority of investors.
Section II(F)(2) of the Proposal discusses the use of historical tax brackets in the computation. Doing so makes every investment company subject to future tax code complexity. For a period of time during 1997, a mid-term gain rate was introduced, which would force any computation of after-tax disclosure to include this rate for the next ten years. For quality control and efficiency purposes, investment companies will naturally want to use computer software to calculate after-tax performance, as we currently do for before-tax performance. The requirement for after-tax disclosure will make any such software vulnerable to sudden obsolescence when any complex change in the tax code occurs.
Furthermore, using historical tax rates for after-tax performance brings to the forefront other problems with the calculation. In 1992, the maximum tax rate was 31%, but in the following year it was 39.6%. The number of investors actually affected by this change was extremely small, but the effect on the proposed after-tax disclosure is quite large. This effect is confusing for that vast majority of investors who are not in the 39.6% bracket, and produces an obscure skewing of longer-term performance. Investors wishing to use long-term performance in making investment decisions could not simply interpolate their expected historical return using their actual marginal tax rate, but would have to look at the historical tax rates as well. It was only twenty years ago that the highest marginal tax rate dropped from over 70% to under 40% in a very short time; such a large move in the future would be quite disconcerting and complex to explain to potential investors.
III. Bond Funds
Because a substantial portion of the return in an equity fund may be due to capital gains, investors may need more information to evaluate the potential tax burden of an equity fund investment. However, for bond funds the bulk of earnings is due to income, not capital gains. Investors anticipate receiving income from bonds funds and understand that it is taxable. Thus the benefit of providing after-tax returns for bond funds is minimal, while the potential for confusing or misleading investors is high.
The SEC's reason for exempting money market funds (section II(D) of the Proposal) also applies to bond funds. While bond funds may generate some capital gains, these amounts are generally small, and bond funds also compete with banking products, which are not required to disclose after-tax performance. This puts bond funds at a competitive disadvantage. Bond funds could be defined as funds which by policy invest at least 65% of their assets in fixed income securities.
While the problems posed by after-tax disclosure for all bond funds are great enough, they are overwhelming for tax-exempt funds. Section II(F)(5) of the Proposal points out that including the alternative minimum tax ("AMT") or phaseouts in calculations of after-tax performance would greatly complicate the disclosure, reducing its usefulness to investors and unfairly burdening investment companies. However, both the AMT and phaseouts are so important to many tax-exempt fund investors, that leaving these effects out of after-tax disclosure for tax-exempt funds makes the disclosure virtually meaningless. In fact some municipal bond funds, such as those offered by First Investors, follow a policy of not investing in any bonds that generate income subject to the AMT. For such funds, the proposed disclosure rule is unduly burdensome and provides virtually no benefit to investors. We believe that all municipal bond funds should disclose whether or not they invest in AMT generating bonds.
Finally, state tax-exempt funds provide yet another level of tax complexity. Section II(F)(4) of the Proposal points out that state and local taxes vary widely and cannot reasonably be included in any computation of after-tax performance. Since the purpose of a state tax-exempt fund is to avoid not only federal but also state income taxes, the inclusion of state income taxes would be necessary to properly disclose after-tax performance for these funds. But requiring this would be overly complicated both for the investor and for the fund. Furthermore, requiring this disclosure would be a competitive disadvantage for state tax-exempt funds, whose after-tax returns would be understated compared to national tax-exempt funds.
We strongly believe that the proposed rule should not apply to bond funds, especially tax-exempt bond funds, because the value to investors is so low and potential to confuse or mislead is high.
IV. Proposed Alternative
Our comments have focused on the problems inherent in adapting any measurement of after-tax performance to the tax code. As we have discussed, any simple disclosure of after-tax performance runs the risk of being misinterpreted by investors, who are likely to compare after-tax performance without taking into consideration the relatively complex problem of adapting the before- and after-tax returns to their own tax situations. This problem is further complicated by the growing number of taxpayers subject to the AMT, who may not know their marginal tax rate.
We propose as an alternative that funds be required to disclose information that would enable anyone to assess the after-tax returns based upon his or her own situation. Under our alternative, funds would disclose a ten-year history of distributions, broken down into short-term, long-term, and income portions and reported both by absolute contribution to N.A.V. and as a percentage of N.A.V. at the time of the distribution. In addition, both the current realized and unrealized gains of the fund would be disclosed, broken down into short-term and long-term portions and reported both as absolute contribution to N.A.V. and as a percentage of current N.A.V. (See example below.) Taken as a whole, this would provide a potential investor with a more complete picture of the tax consequences of investing in a fund than would the disclosure of generic after-tax returns. The advantages of providing such a measure are twofold: first, it would be a measure that is not dependent on the vagaries and complexities (both pre-existing and potential) of the tax code; second, it would enable investors to interpret the measure for their individual tax situations.
N.A.V. per share on 6/30/2000: $12.56
Current Unrealized Gain on 6/30/2000:
Short-Term: $0.35 (2.8%) Long-Term: $2.68 (21.3%)
Realized but Undistributed Gain on 6/30/2000:
Short-Term: $0.03 (0.2%) Long-Term: $0.12 (1.0%)
|Year||N.A.V.||Short-Term Gain||Long-Term Gain||Income|
Regardless of the approach used, we believe any additional disclosure should be located in the tax section of the prospectus, not in the risk/return summary and MDFP. Since tax efficiency is hypothetical and not relevant to many investors, it would be confusing to give it equal prominence with the factual information in the risk/return summary and the MDFP. By placing it in the tax section, it would be easily located by investors interested in the tax effects of their investment.