The Finnish retail investment landscape will change in 2020 as a new kind of non-pension retail investment product, namely Equity Savings Account (ESA), will be introduced next year. Although it remains to be seen how many investors will ultimately end up having one, there has undoubtedly been considerable excitement around the new kind of flexible wrapper.
Suvi Tuppurainen from Nordnet Bank has argued that up to half a million accounts might be opened next year alone. An investor can have only one ESA at the time and deposit up to €50,000 to ESA. The investor can transfer their ESA freely from one provider to another at any time but only have one ESA at a time. The legislation was approved by the Finnish Parliament on 13th March 2019, it was ratified by the President on 17th May 2019, and now different Finnish authorities are working on the practicalities of the new ESA regime so that everything will go smoothly when first ESAs go live at the beginning of next year.
Investment savings account and equity savings accounts have become popular all around the world, and it’s important to remember that the new Finnish equity savings account regime is not unique. There are certainly differences between various non-pension retail investment products, but they all share some common characteristics such as tax-efficiency and tax incentives in the case the investors want to liquidate assets and withdraw money from the account. In many jurisdictions, the stated aim of these schemes is often to boost greater retail investor participation in financial markets through different types of investment savings accounts with tax specific incentives. In the Nordics, the introduction of investment savings accounts (Investeringssparkonto, ISK) in 2012 in Sweden is one of the prime examples of how to encourage retail savings and investing – currently, more than two million accounts have been opened since the inception of ISK in Sweden.
The Finnish ESA model has its advantages and drawbacks
Basically, the Finnish ESA allows the account holder to buy, sell, and hold shares of domestic or foreign companies listed on a stock exchange or regulated venue without being taxed separately by every transaction taking place. Instead, every ESA holder, regardless of their age, experience or their portfolio size, can open their personal equity savings account, and they will be taxed only if cash withdrawal is carried out. Unfortunately, investors can contribute only up to €50,000 in cash at a time to their current ESA although this doesn’t mean that the investor has to stick with one ESA indefinitely; the investor has to sell all his shares and withdraw all the cash from the ESA, and terminate it in order to open a new one. It’s essential to keep in mind that each individual can have only one ESA at the time, and it’s the investors’ responsibility not to have more than one ESA at a time.
The taxation of ESA withdrawals is relatively simple, and because investments are taxed only when a withdrawal is made from the ESA, the fundamental nature of ESA might encourage additional trading and investment activity. Let’s assume that account holder, Matti Meikäläinen, initially deposits €10,000 in January 2020 to his ESA and he manages to make some excellent investments so that at the end of his account market value is €20,000. Although the account market value is now doubled, Matti still has unused contribution room of €40,000 as ESA market value can change, but the market fluctuation doesn’t affect the account-specific maximum contribution room of €50,000 available to him.
More importantly, Matti’s trading activities and distributions received don’t affect his personal taxation as long as he doesn’t withdraw any money out of the ESA. Ultimately only cash withdrawals from the ESA will be taxed if and only if equity savings account market value is larger than net contributions into the account (= Profit/Loss calculation). Although ESA is far from perfect (e.g. foreign dividends taxed at source, deemed acquisition price principle not applicable, capital losses realized only when the whole ESA is shut down, only publicly-listed stocks, only publicly traded stocks, etc.), it is a significant improvement as now investors can now start investing in equities without thinking about immediate tax consequences while accumulating their positions. As it has been mentioned in the report by the working group on the assessment of tax treatment of different investment forms, equity savings accounts might reduce the tax and vendor lock-in effects.
So, for better illustration, let’s suppose that another investor – Tarja Tarjalainen – has contributed €50,000 in net payments to her ESA and she has made a potential profit of €30,000 so that her ESA market value is currently €80,000 in total. Now, Tarja wants to buy a new car, she sells half of his holdings, and she withdraws €40,000, namely half of the market value, from ESA. What happens now?
Basically, according to the new tax rules and principles, Tarja will withdraw half of her invested cash capital, namely €25,000 (net payments), and half of the profits, namely €15,000. So now Tarja has withdrawn €25,000 tax-free as this was her original cash contribution to ESA, and €15,000 as taxable capital income that will be subject to 30%/34% tax (e.g., Tarja will pay €4,500 in taxes if the tax rate is 30%). Ultimately Tarja can buy a new car with her €30,500. On the other hand, on the moment of withdrawal, Tarja’s potential future capital income on the ESA is decreased from €30,000 to €15,000 ceteris paribus, total cash contributions are now under the threshold as €25,000 was withdrawn just a moment ago, and now – if Tarja likes – she could deposit another €25,000 back to her ESA to fill up the maximum threshold of €50,000 in contribution limits.
Push ESA, push ESA right now!
There are many different things that affect household savings and investment behavior. Equity savings account alone won’t change the fact that more affluent, older, and educated people are more like to invest on average than other people for numerous reasons. Although equity savings account is not a particularly innovative financial product in itself, it could make it easier to get started with investing regularly. Why? There are at least a couple of reasons for this. One is that it makes it possible to benefit from the compound interest, and this is easy to illustrate to the prospective investor while of course, highlighting that capital is at risk. ESA will just make it easier for households to channel savings into investments, and my current take is that many families will open ESAs for their children as soon as possible. Another is that it’s easy to sell in terms of its simplicity and in its simplicity, makes it easy to understand for unsophisticated investors.
Many Finnish NGOs (e.g., Finnish Shareholders Association and the Finnish Foundation for Share Promotion), investment management firms (e.g., Nordnet) and media outlets (e.g., Kauppalehti and Taloussanomat), have also been publishing a constant stream of news and opinion pieces around the upcoming ESA.
Here are five predictions of how ESAs might change the Finnish retail investments space:
- The number of ESAs opened in the first year will be something around 100,000-150,000. In 2021, the total amount will grow to 200,000-250,000. In 2025, there will be 500,000 ESAs in total.
- The allocation will be strongly skewed towards Finnish dividend stocks, e.g. Sampo, Tieto, Nordea, UPM-Kymmene, Metsä Board, Elisa, etc. 1)Having dividend-paying shares in ESA is probably not the best move from the individual investor’s perspective in the long run as Vesa Korpela from the Taxpayers Association of Finland has pointed out. In the first year, new ESA holders will most likely also seek to increase their exposure to foreign equity to better manage portfolio risk through diversification.
- Net payments to ESAs will be significant in the first year. I assume that the total net payments will be approximately one billion euros in 2020 alone.
- We will most likely see new commission and pricing models emerging. In the beginning, pricing is not going to be very innovative either, but especially incumbents will most likely bundle ESAs with their other product offerings to cater to a broader customer base than investment management specialists.
- One or two players will dominate the market. My sincere hope is that at least some of the ESA players will offer innovative financial guidance to their clients, e.g., in-portfolio simulation tools, rebalancing options, filtering and sorting, and advanced portfolio analytics. ESA is a great gateway product, and it could be used both as a way to create better engagement as well as upsell more advanced investment services.
I think that ESAs will affect the retail wealth space both directly and indirectly, i.e., outflows and inflows on different financial products. We will see in the upcoming years if some of my predictions about ESAs come true.
Besides, I believe that ESAs will probably also make it likely that at least some of the current passive retail clients opt to do it themselves. There is a growing segment of the wealth market that is not interested in paying for financial advice, and if they have market exposure already, they might use ESAs to grow their buy-and-hold portfolios. On the other hand, active traders will also most likely benefit from ESAs as transactions per se won’t trigger tax consequences.
What will happen next?
Competition in brokerage and other execution and trading-related business is a global phenomenon, and in Finland, there have already been some signs of increasing price pressure and margin erosion, new players (e.g., Mandatum Trader in 2019, Evervest in 2015), diversifying product universe and quality content, making and savings easier, cheaper and more accessible to prospective investors.
Although there is still a lot of work to be done to promote financial literacy and education in Finland, ESAs might act as an essential factor in the equation of increasing the awareness around savings, investing and ownership. It’s crucial, of course, to acknowledge that ESA is not the silver bullet, and there might be situations that it makes more sense not to invest at all or invest via different vehicles or instruments. Incumbents – traditional banks, brokers, and investment firms – are currently developing their own ESA-related offerings.
Investors should be celebrating the 10th birthday of the Great Bull Run. Many market participants and commentators are increasingly skeptical whether global equities can still go higher, but one thing is pretty clear. Risk-averse savers, namely those persons and households that have significant cash holdings, have been on the losing end of the game as deposit rates have stayed very low for years due to the low-interest-rate environment. The real interest rate on deposits is still negative, and therefore, it makes sense to take at least some risks to protect the actual value of (financial) holdings.
The upcoming ESA, coupled with the changing market dynamics, means that there will be more competition in the retail investments space. As Tanja Eronen from Nordea Wealth Management noted in Kauppalehti, “You lose some market share if [the bank] is unable to offer equity savings account right away.” At the same time, as Aki Pyysing has recently noted, the Finnish tax system has been pretty unpredictable lately, and every Finnish investor remembers what happened to the long-term savings accounts a couple of years ago.
My view is that banks and eligible investment management firms are going to actively target both existing and new investors with ESA. For the beginner, ESA offers a compelling option given the complexities and tax considerations with direct investments; best players in the market will understand this and most likely launch ESA setups that will be different from plain vanilla trading accounts. I hope that at least some of the players will take into consideration that it could make sense to offer ESAs bundled with other products, advisory, and education so that investors will make a better financial decision.
Moreover, ESAs might also attract totally new people – namely those who are currently noncustomers – to the market, and it’s crucial to find efficient ways to customize ESAs at scale. I believe that at least some players will most find ways to adaptively customize ESAs without any direct customer interaction with the account provider. For example, some players might offer some additional functionalities, market data, or transparent reporting so that they will be better aligned with their clients’ needs and their willingness to pay for ESA.
Now I just wait when and how different players will come out with their equity savings accounts. I believe that we are going to see some pretty imaginative go-to-market strategies unfolding. Or we don’t. Time will tell.
In my next article on the Finnish equity savings accounts, I will take a look at some of the information that has been put forward by the Finnish media, banks and other financial service players about ESA. I provide a general overlook of the ongoing developments, and if some of the prospective ESA providers seem to do promotion, as Nordnet already appears to do proactively, I will provide some analysis of these emerging approaches.