Considering International Taxation on Dividends When Selecting Passive Equity Strategy

March 19, 2019

When a plan sponsor evaluates a non-U.S. equity index fund for its ERISA qualified defined benefit or defined contribution retirement plan, the primary determining factors are typically investment management fees and tracking error. As a result, a mutual fund is often utilized, given participants’ desire for a ticker symbol and the ability to obtain the latest information on the fund from independent third-party services such as Morningstar. But when thinking about opportunities to save on investment management costs, plan sponsors have recently begun considering a passively managed strategy over the historic actively managed equity market strategies.

When the decision is made to implement equity passively in an ERISA qualified plan, relatively little thought goes into selection of the type of investment legal structure. Most individual investors across the defined contribution (DC) landscape invest in a mutual fund. On the surface, this may seem like an appropriate decision if the mutual fund vehicle has adequately tracked its relevant equity benchmark with a reasonable fee. However, a less considered but equally important factor, because of the international tax treatment of dividends, is the type of investment vehicle.

Within non-U.S. equity, we believe plan sponsors should more deeply analyze the type of investment vehicle that should be utilized, because the international tax treatment on dividends is a hidden drag on performance—a disadvantage to mutual fund investors when compared to similarly positioned commingled investment trusts.

While most qualified plan investors are taxexempt organizations, the investment vehicles they utilize may not be. This is certainly the case with non-U.S. equity investing. Countries outside the United States impose taxes on dividends at varying rates. Some countries levy no taxes on dividends, but Canada, for example, levies a 25% tax, Sweden levies a 30% tax, and the Czech Republic, Chile, and Switzerland levy a 35% tax.

MSCI does not adjust the stated investment performance of its non-U.S. equity benchmarks for each country’s varying dividend tax treatment. Instead, most non-U.S. equity benchmarks constructed by MSCI assume full tax collection. As a result, the dividend tax rate for mutual funds tends to mirror those levies. However, pooled investment vehicles (i.e., commingled investment trusts) with the U.S. 81-100 tax classification benefit from more favorable tax treatment. This is due primarily to the fact that qualified plan investors are the only “end investors” in a collective investment trust vehicle.

A  reduction in tax collection can significantly improve investment returns. For example, while the tax levied on dividends is 25% in Canada, the tax collected on dividends for investment vehicles classified as U.S. 81-100 falls to 0%. The same holds true for dividends from Swedish stocks—Sweden’s tax rate falls from 30% to 0% based upon the type of investment vehicle utilized.

The headwinds of dividend taxation will vary over time. Looking at data based upon dividend yields and country allocations over the trailing five-year period ending June 30, 2018, Aon calculated the average annualized performance deficit for mutual fund investors at roughly 15.1 basis points, using 2018 tax rates. Over the time frame analyzed, the annualized deficit ranged from 13 basis points to 16 basis points in any given quarter.

The chart above highlights the performance differential from quarter to quarter.

As investment management fees for passive investment vehicles continue to trend toward zero, the hidden cost of dividend taxation is noteworthy for passive non-U.S. equity mutual fund investors in a defined contribution plan’s core investment menu. A similar obstacle also applies to passively implemented non-U.S. equity strategies within a target-date retirement fund. For example, based upon our analysis, a 30% allocation to passive non-U.S. equity within a target-date retirement fund may equate to a 4.5-basis point net performance headwind for two equally priced solutions over a five-year period.

We realize that there may be circumstances (i.e., 403(b) plans) where a plan sponsor must select a mutual fund investment vehicle. As a result, we continue to believe that non-U.S. equity mutual fund investment vehicles remain institutionally sound. However, when qualified plan investors can invest in a commingled investment trust, it is important to remember there are dividend taxation advantages that may surpass the relative differences in expense ratios.

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