Comment on ‘Household Portfolio Choices in Taxable and Tax-Deferred Accounts: Another Puzzle?’

Using an arbitrage approach, Black (1980) and Tepper (1981) conclude that the optimal corporate pension policy is for companies to fully fund their pension plans, borrowing on corporate account if necessary, and investing the pension fund entirely in taxable bonds. The implications of the Black-Tepper arbitrage results for optimal asset location for individual investors were first discussed in Dammon et al. (1999). They demonstrate in their numerical analysis that the investor should optimally hold taxable bonds in his tax-deferred account and stocks in his taxable account, borrowing if necessary to achieve the optimal overall risk exposure. When the investor faces a binding borrowing constraint, he may hold some stock in his tax-deferred account, but only if his taxable account is entirely invested in equity. This optimal asset location policy was later formally derived by both Huang (2000) and Dammon et al. (2004) using the Black-Tepper arbitrage approach. Studies by Shoven (1999), Shoven and Sialm (2002), and Poterba et al. (2000) provide an alternative view. They argue that because many actively managed mutual funds distribute a large fraction of capital gains each year it can be optimal to hold equity in the tax-deferred account and tax-exempt bonds in the taxable account. However, Dammon et al. (2004) demonstrate that holding equity in the taxdeferred account, and tax-exempt bonds in the taxable account, is optimal only if the form of equity holding is highly tax-inefficient and significantly outperforms a tax-efficient index fund. Given the well-documented evidence on the underperformance of actively managed mutual funds, Dammon et al. (2004) conclude that investors would be better off holding index funds (or individual stocks) in the taxable account and taxable bonds in the tax-deferred account.