Banks in the mutual fund business should take heed - ch1ange is on the horizon. Mutual fund regulations requiring disclosure of after-tax rates of return have been proposed and may soon be required by the Securities and Exchange Commission.

With millions of Americans investing trillions of dollars in mutual funds, the new SEC rule may prove to be one of the decade's most important for financial institutions.

Today the typical mutual fund investor trying to comparison shop has no way of telling which of two funds with identical before-tax returns is the poorer investment because of higher taxes. Some mutual funds lose as much as 5.6 percentage points of their total returns each year to taxes, while others lose nothing. The average tax bite is 2.5 percentage points. Banks should be interested in the proposed SEC changes for these reasons:

  • Many banks offer their own mutual funds.
  • Most banks are now in the business of advising clients on financial investments, even if they don't offer their own mutual funds.
  • The changes proposed by the SEC will help banks give customers better information about investments.
  • Investors need and are beginning to demand more-sophisticated information, such as after-tax performance, from all funds, all the time, in a consistent and clear format.

Banking executives should know about several key after-tax issues facing the SEC and how the SEC proposal addresses each issue.Calculating after-tax performance. The SEC wants to calculate after-tax performance assuming that the distributions are taxed at the highest individual federal income tax rate. This provides a worst-case scenario - an upper boundary that banks can compare against the fund's before-tax return to see the full range of potential returns.

Computing state and local taxes. The SEC wants to stick to the impact of federal taxes and not ask funds to compute the thousands of state and local taxes that could apply. A standard figure that applies across the nation is easier and less confusing.

Applying tax rates. The SEC believes that when a fund makes a distribution the only appropriate tax rate is the one in effect at the time of distribution - the historical tax rate.

Applying taxes to capital gains.The SEC wants funds to track the actual holding periods of reinvested distributions and apply the appropriate tax rates for each reinvestment and the initial investment. Multiple capital gains rates can vary significantly and severely penalize an investor's gains. Funds have the means and should be required to calculate this.

Comparing funds with different load structures. The SEC has proposed that funds report after-tax returns in two ways: pre-liquidation and post-liquidation. The problem with this approach is that the pre-liquidation return reflects front-end but not back-end sales charges, since back-end charges apply only when the shares in the fund are sold. The back-end load shows up in the post-liquidation return, but it's obscured by the additional taxes that come with the sale of fund shares. The proposed rule makes front-end loaded funds look worse and back-end loaded funds look better. This leaves bankers in the dark, trying to compare funds with different sales charge structures.

The solution is to drop the before- and after-tax pre-liquidation returns and replace them with one calculation - the rate of return, net of sales charges and taxes on fund distributions. The new figure would set aside the tax impact of the decision to buy or sell fund shares, thus isolating the tax impact and giving investors a consistent number to use in comparing funds. Stick with the SEC's plan to offer two other post-liquidation figures - before-tax and after-tax returns - and banks have the fullest possible picture of a fund's performance.

The SEC should be commended for its proposal to disclose the after-tax performance of mutual funds. Its proposed regulations have the potential for a bank to help its customers - and itself - enhance the bottom line.

We recommend that banks contact the SEC to urge adoption as soon as possible of its after-tax disclosure proposal with the minor modifications proposed above. In addition, banks that offer their own mutual funds should begin investigating the various options that exist to provide after-tax rates of returns. Banks that heed the warning and prepare now will have a smooth transition when the new SEC regulations take effect.

Mr. Evans is president of Confluence Technologies Inc., a Pittsburgh provider of investment performance measurement systems for mutual funds.

Note to Readers

"Viewpoints" is a regular feature in American Banker, appearing every Friday. It serves as a forum for discussion and debate on a wide range of issues in the financial services industry, including management approaches and strategies, legislative and regulatory matters, and public policy in general.
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