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Investing Insights: Retirement Spending and Hidden Gems

Our analysts look at oil prices, moat upgrades, and passive sustainable investing on this week's episode.

Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.


Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Figuring out how much you are going to spend in retirement is an important part of the retirement planning process. I'm here with Christine Benz, our director of personal finance, and she is going to explain why it helps to go beyond just these rules of thumb.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: Let's talk about why this is important, first. Why do you need to know how much you are going to spend in retirement?

Benz: It's really one of the key inputs into the formulation about whether your retirement plan will be viable. I always tell investors to start with looking at their anticipated spending in retirement. Then they will want to subtract out any certain sources of income like pensions, like Social Security. The amount that they are left over with is the amount that their portfolio will need to step up and replace on an annual basis. You would take that amount and divide it by the portfolio's value to determine your withdrawal rate, and then you can do some testing around whether that, in fact, is a sustainable number, whether your planned withdrawals are sustainable. Really, it's the linchpin for doing any sort of calculation about your retirement portfolio's viability.

Glaser: That's a really straightforward calculation, but some of those inputs aren't all that straightforward. How do I know what I'm going to spend? Where do I start to get that number?

Benz: Really, the starting point is to look at your current income today, which is not to say you will spend all of your current income while you are working, but that's kind of your baseline that you'd want to start out with. If you are a younger person who is well under retirement year, you probably want to take a step back and think about nudging up your baseline starting amount. If you are expecting that you will get cost of living increases down the road, or if you expect that some of the categories that you will spend on in retirement will inflate, you will, of course, want to nudge up your number. But that's the baseline. Say, you are someone who is a couple of years away from retirement, start by looking at your current income from your job.

Glaser: There's going to be some expenses you don't have in retirement. One of the big ones is saving for retirement.

Benz: That's exactly right. To use a really simple example, let's say, someone is making $100,000, and they are saving 20% of their salary. Well, that means that they have an income need in retirement that's just $80,000 because they have been a heavy saver in the years leading up to retirement. Our colleague David Blanchett, who is head of retirement research for Morningstar, has found that generally speaking, the more affluent you are, the higher your pre-retirement savings rate is. That means that your income replacement rate can be that much lower.

Glaser: What about tax savings?

Benz: That's another factor to bear in mind. Some retirees do realize significant tax savings in retirement. One of the line items that comes off the top for nearly all of us is that if we have been paying FICA taxes, if we've been paying Social Security and Medicare taxes and they have been getting deducted from our paychecks, well, that's 7.65% of our paycheck. That's another percentage that you can take off the top when looking at your anticipated in-retirement spending.

Glaser: Finally, if retirees are dreaming of taking that big cruise or another big vacation, or how their lifestyle changes, how do you factor that in to what that income requirement is going to be?

Benz: There are a lot of different factors in the mix, certainly. One of the big ones to look at though is housing-related expenses. If your plan is to stay in place, to age in place throughout your retirement years, you probably won't see any big changes. But if your plan is to downsize or to relocate to a cheaper part of the country, you may, in fact, realize some significant cost savings. Start with housing costs because that will be one of the bigger line items in your budget.

In terms of other types of costs, food is another category to look at. David Blanchett found in his research on retirement spending that that's one area where we tend to see retirees find cost savings. Maybe they don't have lunch out as much or they have more time to prepare food at home or shop for food, shop for values in food, whatever it might be. We tend to see like a 5% or 6% reduction in terms of the outlay for food costs.

Then in terms of all of the other leisure expenses, I think, it's up to each retiree, pre-retiree to take a step back and think about what their plans are and how costly those plans are, whether it's travel or golfing every other day or whatever it might be to take stock of what those hobbies and what those great leisure activities could actually cost and what effect they might have on the budget.

Glaser: Finally, I have to ask about the elephant in the room, which is healthcare. Those costs are somewhat unknowable. How do you factor that in?

Benz: They are unknowable. But I do think that Fidelity's annual research where they look at the expected outlay for healthcare costs for a 65-year-old couple is a good starting point or at least food for thought when thinking about how much to set aside for healthcare expenses.

The most recently released number was $280,000 for a married couple 65 years old throughout their retirement years. That encompasses supplemental insurance policies. Medicare doesn't pay everything. It encompasses prescription drug costs. It encompasses co-pays. Dental is another big surprise cost for many retiree households if they have been covered by insurance in the past. Typically, if you add dental insurance to your supplemental policy coverage, you are going to pay for that coverage. $280,000 was the most recent estimate and it does not include long-term care costs. If you have unfunded long-term care costs, you would obviously want to set those aside as well, and that's another huge consideration. But that's certainly one of the numbers that when we look at retiree budgets, we tend to see expenses go up there.

Glaser: Christine, thank you.

Benz: Jeremy, thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.


Christine Benz: Hi, I'm Christine Benz for Many Vanguard funds are large and getting larger, but a handful of the firm's funds are still relatively small. Joining me to discuss some of the better ones is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: We've been observing this Vanguard juggernaut where it seems like every time we talk about fund flows, we see more and more flows going to Vanguard funds. But there are a small handful of funds that haven't yet accumulated a lot in assets. You took a look at medalist funds that don't have huge asset bases at this point. All of the funds that you pulled actually have asset bases of less than $3 billion. I want to talk about some of them with you, Russ.

The first is Vanguard International Dividend Appreciation. I think a lot of our viewers are probably familiar with Vanguard Dividend Appreciation, the U.S. equity version; this is an international spin on the same general idea, right?

Kinnel: That's right. This fund was launched about two years ago and so far, it hasn't taken off the way the U.S. version has. It really has a lot of the same characteristics. They look for companies that have paid rising dividends seven years in a row. It's a large-cap index, obviously, with a nice yield, very low cost despite it still being a pretty small fund. It's got a lot of promise. So far, performance has been nothing special, nut it's only two years out of the gate and it's an index fund. I'm not too worried about that part of it.

Benz: This is one, as is Vanguard's tendency, where we've got the index traditional mutual fund and you also have an ETF that's run as a share class of the traditional mutual fund. The ticker of the ETF is VIGI. Do we have a preference about whether investors go for the traditional index mutual fund or the ETF?

Kinnel: Not at all. They are both very cheap. It depends on a little bit about transaction costs, who you are buying it through, and whether doing additional investments will cost you money. Obviously, if it does, then I would go with the open-end. But they are both very cheap. I don't really have a preference, no.

Benz: That one is Bronze-rated, correct?

Kinnel: That's right.

Benz: OK. Another fund that is actively managed--well sort of actively managed and you are going to talk about that--is Vanguard US Value. This one is Silver-rated. It's large-cap value. Let's talk about this fund.

Kinnel: It's an actively managed fund under 30 basis points and under $2 billion in assets, a really good deal. Vanguard doesn't wait for a fund to get huge before they start giving you a good deal on fees.

The story here is, this is run by Vanguard's quantitative equity group which looks at five equity factors with a value tilt obviously. They have done very well. Since the fund switched to this strategy after 2010, the fund has beaten the Russell 1000 Value as well as its peer group. Very strong, stable strategy. As you often have with quant funds, very diversified, because they don't want one stock overwhelm performance. But it's done really well, low-cost. I think quant funds are just by their nature, no one warms up to them. It's like is it an index fund, is it an active fund? The answer to both is well, it's not really an index fund. But people don't like quant funds, but I think there's a lot of appeal here.

Benz: Maybe investors would be less likely to performance chase or something if there's not a star manager who is running the show?

Kinnel: That's right. There's isn't a star manager. It's very much a team of quants running the strategy. And we recently raised it to Silver because we really have a lot of conviction in the fund, especially at these costs. They don't have a lot of ground to make up just match an index.

Benz: Some investors might be looking at their portfolios and see that the value component of their portfolios hasn't performed so well, so maybe they want to add some money to that value column of the style box. Is this kind of pure play value fund, would you say?

Kinnel: Relatively. There's momentum factors and others. I would say it's definitely value. It wouldn't call it deep value though.

Benz: The next fund that is not yet large is Vanguard Global Minimum Volatility. This is Silver-rated. It's not an index fund either, but it is pretty hands-off in terms of its management style. Let's talk about this one.

Kinnel: That's right. It's technically not an index because it doesn't exactly seek to match its benchmark, which is FTSE Global Index. Essentially, you're looking at big companies, but because they are looking to reduce volatility, they go from within that index to slant to the companies that they think will be less volatile. Not just looking at beta but other factors as well that seem to line up with less volatility. Then on top of that, they hedge back the currency risk because of course currency has a fair amount of short-term volatility. Though from a long-term perspective, it doesn't really add a lot of risk. What you get is this nice global, very low-cost, nearly passive fund that I think is a really great idea especially if you have someone in a retirement account because I think at that point you want to reduce volatility as much as you can, but I also don't think many investors can afford to avoid foreign equities. I think foreign equities have a lot of return potential, and they really don't have more risks than the U.S. outside of that currency issue. I think this is a really good fund that's been kind of overlooked.

Benz: You stated the case for this low-volatility strategy. There's also some data to point to low-volatility strategies outperforming which seems kind of counterintuitive. You might expect them to hold down risk, but actually, in some market environments they look better on a returns basis.

Kinnel: That's right. These low-volatility strategies have been tested and people found good returns. But I think even if the absolute returns are not superior, on a risk-adjusted basis they should be good. But also, when you think about our investor returns research, we know that less volatile funds work better for investors because it doesn't give them those highs and lows. It doesn't make them panic or get greedy. There are a lot of things to like about a low-volatility strategy.

Benz: Russ, thanks for sharing your insights. Thanks for being here to share a short list of Vanguard hidden gems.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for


Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with senior analyst David Meats. He thinks current oil prices are frothy. We're going to talk about why and what it means for investors.

David, thanks for joining me.

David Meats: Of course. Thank you.

Glaser: Right now, oil is trading at about 25% above where your estimates of where it should be midcycle. What are some of the drivers of this big runup in prices we've seen recently?

Meats: Demand growth has been a lot stronger than we expected. But I think that a lot of the main drivers of the rally are on the supply side. We've seen excellent compliance from OPEC with the production cuts. Venezuela has been a bit part of that, of course, with its production falling by half a million barrels a day since December. Of course, you have the potential, the fear in the market about the impact of the restoration of sanctions on Iran, which could potentially put another million barrels a day of supply at risk.

Glaser: Do you think this is sustainable or are we going to see oil prices come lower?

Meats: You have to think about the impact on the U.S. We haven't really seen the full impact of the U.S. shale growth machine yet. There's probably a hundred more oil rigs active in the U.S. today than there really needs to be to keep the market adequately supplied in the long run. I think that if you don't get the right price signal to those U.S. producers, the growth trajectory that we are on right now is dangerous and could potentially cause a glut down the road. One way or another, I think, you need to see lower prices sooner or later.

Glaser: What's your estimate? Where do you think prices are going?

Meats: In the long run, we think the marginal cost of supply is about $55 a barrel. I think over in the next, let's say, 12 to 18 months, you will see prices drift lower as the market recognizes that full potential of the shale sector.

Glaser: But there's a fair amount of uncertainty here into exactly when we could get to that price?

Meats: In the short term, there's huge uncertainty because on the demand side, you have to consider the impact of a potential trade war, for example or the price elasticity of demand. As gas prices are getting higher, people are less incentivized to put gas in their tanks and take long trips. That could have a negative impact on demand as well. Whereas on the supply side, maybe Iran can circumvent the sanctions since the European partners to the deal aren't likely to participate. Or maybe Venezuela can find a way to recover some of the volumes that it's lost. Really, you can create incredible scenario either for undersupply or oversupply in the next 12 to 18 months. But going beyond that, you really need the prices to move lower or you will be just handing too much share to the shale producers and sending them the wrong price signal to accelerate growth when it's not required.

Glaser: Let's talk about the investment implications here. We've seen a runup in some of these oil companies along with prices. You think that it's mostly unsustainable, but are there any values there?

Meats: Yeah. I mean, that's the issue. With the runup in oil prices, obviously, those are highly correlated with stocks, and that makes a lot of the stocks in the oil sector very expensive as well. There are some pockets of value. We prefer companies that are very low cost and have very strong balance sheets, the ability to tolerate the lower prices that we forecast. One of those names is Diamondback Energy. The ticker is FANG. That's essentially the industry cost leader and it does have that excellent balance sheet, the ability to tolerate prices or really thrive at the prices that we are seeing today. But in general, E&P stocks do look expensive and for the most part, I think, investors are better off waiting for a pullback.

Glaser: David, thanks for the update today.

Meats: Of course.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.


Seth Goldstein: We've recently upgraded Ecolab to a wide moat rating from narrow as we think the company's switching-cost moat source has strengthened.

Ecolab is the largest supplier of cleaning and sanitation products in the world. The company's razor-and-blade business model creates customer switching costs as Ecolab's cleaning equipment requires customers to purchase the firm's proprietary consumables.

In addition to a continual emphasis on reducing its customers' water, energy, and labor expenses, Ecolab now offers equipment that will automatically keep regulatory compliance records. This regulatory aspect strengthens Ecolab's moat as customers would face increased compliance costs by choosing a competitor. Further, Ecolab focuses on cross-selling products, which also contributes to switching costs. For a customer with cleaning and sanitation needs, managing each order from a separate supplier has a fixed-cost component. Through the scope of its products, Ecolab serves as a one-stop shop, which saves its customers time and money aggregating orders and re-orders by engaging solely with Ecolab.

Although Ecolab's stock currently trades above our $141 per share fair value estimate, the company's strong competitive advantage should lead Ecolab to generate returns above its cost of capital for years to come.


Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently published a survey of the passive sustainable investing landscape. I'm here today with Jon Hale, he is our director of sustainable investing research, to look at what's happening in that space.

Jon, thanks for joining me.

Jon Hale: My pleasure.

Glaser: Let's talk a little bit about that intersection of passive and ESG. I know we've talked before about how sustainable investing is not about creating these rigid screens. But how does that translate into a passive rules-based strategy then?

Hale: Jeremy, the development and increasing sophistication of ESG company-level research over the last decade or so has made it really possible to do passive ESG indexing in a way that in years past it was primarily oriented toward maybe a few exclusions and then that was pretty much it. But now, what you can do is structure a portfolio around companies that, based on ESG research, are those that do a better job addressing pertinent environmental issues, social issues, that engage in best practices in corporate governance. These are companies that over the long term are fairly likely to have good risk-adjusted returns and are high-quality companies. It's more possible today to create an index based on ESG factors than ever before.

Glaser: Let's talk about how some different index providers are actually creating these indexes then. Are they all looking at company-level research? Are there other factors at play?

Hale: I would say, pretty much everyone is looking at company-level research. But you could think of--especially, the broad-based ESG indexes. But you can sort of think of these in three types of categories. There is the broad-based index that could substitute for a market-cap-weighted conventional index. You've got that. You've got over on the other side some very thematic-oriented indexes around things like renewable energy or green bonds. And then kind of in the middle you have, what I would call broad thematic approaches that are diversified portfolios, but they focus more intently on issues like low carbon, fossil fuel-free, for instance, or gender diversity.

Glaser: Have these funds started to take off? Has there been a lot of investor interest in them?

Hale: There's a lot of investor interest, on the one hand, in ESG-oriented investing, and on the other hand, in passive investing. The number of these funds has taken off. We have not seen an avalanche of assets go into them yet, but I think what we are seeing is, asset managers and index providers developing the products that will be able to meet the demand going forward.

Glaser: For an investor who cares about sustainability, is the decision between going active and passive the same decision that they'd be making if they were looking at conventional funds or are there any other special considerations?

Hale: It is generally the same kind of decision. If you are interested in both sustainable investing and passive investing, there is no reason why you shouldn't go the passive route. I think the one area that they ought to be thinking about if you want to go passive and sustainable is, is the asset manager engaging with companies as a shareholder. In some cases, with index providers, the answer is, no; in other cases, it's yes. For instance, iShares, owned by BlackRock, we know BlackRock has been quite active in shareholder engagement and I think that's something that's important for sustainable investing in general. I think the sustainable investors themselves feel like they have a greater impact with their money by investing in those kinds of portfolios.

Glaser: Jon, thank you.

Hale: My pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.


Linda Abu Mushrefova: Prudential Jennison Mid Cap Growth and Hartford MidCap are both solid options in the mid-cap growth Morningstar Category and both have a Morningstar Analyst Rating of Bronze.

Prudential Jennison Mid Cap Growth offers attractive downside protection and has rewarded investors over time. The team uses a disciplined approach in which they seek to identify names that demonstrate steady growth. These names make up the bulk of the fund's portfolio with a smaller portion made up of names that have higher growth prospects but are riskier. Valuation is also a key consideration with the team modeling names out on a three-year time horizon. This is a measured approach that is a good option for investors seeking a moderate risk/reward profile in the mid-cap growth space.

Hartford MidCap takes a slightly different approach to the mid-cap growth space. Their process emphasizes identifying companies that have demonstrated a high or growing market share and uses a variety of valuation metrics to inform the team on valuation. The team is experienced and has rewarded investors over the long haul. However, it has done so by outpacing peers on the upside but has not offered downside protection. 

Investors seeking a relatively more conservative option that offers downside protection at the expense of some of the upside might be best served in Prudential Jennison Mid Cap Growth. Conversely, investors seeking a relatively more aggressive strategy that has outperformed peers on the upside at the expense of downside protection should consider Hartford MidCap. Both are backed by experienced teams and have reasonable fees. We expect both funds to deliver over time.