Compounded or confounded

Question: How can investments in mutual funds, unit investment trust funds and even variable unit-linked insurance policies compound income when they don’t even pay out interest? – asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph and Facebook.

Answer:  Investopedia defines compounding as “the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings…Also known as “compound interest.”

On the other hand, Investopedia defines compound interest as “interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan…The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest.”

The confusion arises because the time deposit-oriented Filipino cannot grasp compounding without any payment of interest.  Nevertheless, compounding still applies to mutual funds, unit investment trust funds and variable unit linked insurance policies commonly known as pooled funds because it is earnings and not interest that is the focus.

The term “earnings” implies that income is not guaranteed like interest.  But earnings left in the investment can also be reinvested and, therefore, made to potentially earn some more.

Earnings are more akin to the net income of a company from which cash dividends are sourced. Cash dividends are like interest except that they are not guaranteed. Moreover, cash dividends have to come only from the unrestricted earnings of a company.  Restricted earnings are the ones that get reinvested so that they too can earn income for the company and its stockholders.  And it is in this manner that earnings of pooled funds are compounded.  All of these funds’ earnings are considered as restricted.  Compounded earnings translate to higher pooled fund values either in the form of higher net asset value per share or net asset value per unit.

Now do pooled funds ever pay cash dividends?  Strictly speaking, only companies pay cash dividends as they are the only ones whose form allows for stockholders. Unit investment trust funds and variable unit-linked insurance policies are not standalone companies but mere products of their sponsor financial institutions.

Only mutual funds pay cash dividends because mutual funds are corporations.  But in practice, would mutual funds pay cash dividends?  Mutual funds will most likely not pay cash dividends because any payment of cash dividends by corporations to individuals will be subject to the final 10 percent cash dividend tax.

On the other hand, income realized from the sale of mutual fund investments is exempt from any form of income tax. Section 32(B)(7)(h) of the National Internal Revenue Code states that excluded from the computation of gross income are “Gains realized by the investor upon redemption of shares of stock in a mutual fund company as defined in Section 22 (BB) of this Code.”

So instead of paying out cash dividends to its shareholders and subjecting the same to the final income tax of 10 percent, mutual funds will just invite its shareholders to have redeemed the number of shares that will be equivalent to what such shareholders want to receive in terms of equivalent cash dividends. Any gains to be reflected on such redemptions shall be exempt from income tax.

The rationale for the exemption of mutual fund gains from income tax is because such investments would have already been taxed the final withholding tax of 20 percent on interest income and/or the stock transaction tax of 1.5 percent while such investments were still part of a mutual fund. If such investments were withdrawn with the gains subjected to income tax, there would be double taxation.

So again, while pooled funds do not pay out interest, they still benefit from compounding their earnings.  And as a general practice, earnings of pooled funds are considered restricted earnings, which are meant for reinvestment, thereby allowing for the compounding of earnings.

If you want to know more about compounding, avail of our free tools at www.personalfinance.ph.

(Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-505-0709 or emailed to [email protected]. To learn more about value investing strategies, 54th Registered Financial Planner (RFP) program this May 28 to July 16, 2016. To inquire, e-mail [email protected] or text <name><e-mail> <RFP> at 0917-9689774.)