Take the example of someone with a portfolio with 50% fixed-income funds and 50% growth funds, including $100,000 in an RRSP and $100,000 in a TFSA. The optimal and traditional way would be to allocate pre-tax assets based on an ideal account, i.e., prioritize fixed income funds in the RRSP and growth funds in the TFSA, represented as follows:

However, to illustrate the effect on purchasing power, returns must be converted into after-tax amounts based on an average tax rate estimated according to the objective. In this case, we assume that the savings are for retirement, and that the average tax rate at retirement is 40%. We therefore obtain the following actual exposure based on purchasing power:

We can see that there is an overweight in growth funds in an after-tax environment. So the portfolio is riskier, and therefore much more volatile.

In finance, when we talk about risk and volatility, we are actually referring to the standard deviation. This well-known concept measures an investment's performance compared to its average returns over a given period of time.

Since the calculation of the standard deviation depends on returns, we must calculate it after taxes.

Take the example of an RRSP with annual pre-tax returns of -2%, 4% and 10% over a three-year period. The average pre-tax return is 4% and the standard deviation is 6%. If we assume a 40% tax rate, the average after-tax return is 2.40%, or [4% X (1-40%)] and the after-tax standard deviation is 3.60%, or [6% X (1-40%)]. In this case, the person would have received 60% of the returns and assumed only 60% of the risk.

Not convinced about after-tax volatility? A loss of $10,000 in an RRSP with a 40% tax rate is actually a $6,000 loss in after-tax purchasing power, as opposed to the same loss in a TFSA, which is equivalent to $10,000 after taxes. A loss in an RRSP will be smaller than the same loss in a TFSA!

However, this doesn't mean that we need to take more risks with the RRSP but rather that we should consider the after-tax allocation of assets to standardize the risk involved.

Based on this logic, once we have allocated after-tax assets, we would obtain the following:

Finally, we need to convert these figures into gross amounts to obtain the actual amount to invest: 

The after-tax allocation method is only starting to be used by most financial institutions, portfolio managers and compliance. The most difficult part of this method is to estimate the tax rate. But using the traditional approach is literally assuming that the tax rate will be nil, which is incorrect.

In the same way as we choose to present an after-tax financial balance sheet, it is preferable to estimate the tax rate based on asset allocation rather than act as if there is no tax.

Would you make retirement projections without taking into account the taxes to pay when withdrawing funds from an RRSP? So why wouldn't you do it for investments?