Investing Insights: Retiree Taxes and ETF Picks

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the new tax laws going into effect for 2018, many retirees are wondering how that might affect their tax bills. Joining me to discuss that topic is Tim Steffen. He is director of advanced planning for Baird Private Wealth Management.

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine.

Benz: The topic I'd like to cover today is retiree taxes. There is a lot that's changing starting in 2018. First, let's discuss an overarching principle for thinking about tax payments throughout the year. How should investors approach that question?

Steffen: The general theme we try to encourage with investors and taxpayers is, when you are figuring out how much to pay during the course of the year, you want to pay just enough tax during the year to avoid getting hit with an underpayment penalty. You don't want the IRS will penalize you for paying too little. But you don't want to pay all your taxes upfront. You want to maintain the use of that cash for as long as you can. You pay just enough to avoid the penalty and then plan to have a balance due when you file your tax return in April.

A lot of people don't like to do that. They don't like writing their check at the end of the year. They prefer to get the refund. But you're making an interest-free loan to the government when you do that. I think when people think of it that way, they think, I'd rather maintain the use of my money. So, in general, you want to pay as little as you have to during the year and then write the check in April.

Benz: One of the ways that taxpayers try to figure out, well, how much will I owe for a given year is to look back to the previous year. We have a big change in terms of the tax laws starting in 2018. What are the perils of using your 2017 return, what you paid in 2017, to determine how much you should be paying throughout 2018?

Steffen: As you said, one of the ways that people look at how much do I have to pay and to avoid that penalty, what's that target I have to hit, there's a couple of different things that you can look at. One is paying in off of last year's tax liability and one is paying off of current year tax liability. The easy thing is to pay off what you paid last year. For most people, that's 100% of your prior year tax liability and that's not the balance due in April. That's the total taxes you paid during the year. Either 100% of that--some people with higher income obviously have to shoot at 110%--but at least that's a fix number. So, it's really easy. You know what the number is. You just take that number, divide it by four, and you make payments during the course of the year or something like that.

The problem with that this year is, we've got this tax reform hanging out there. And there's a lot of changes happening in 2018. While not everybody is going to see lower tax liabilities in 2018, the studies are showing that the vast majority of people will, upward of maybe 80% of taxpayers, will pay less in 2018 than they did in 2017, all things being equal. For those taxpayers who are going to see a fall in their tax liability this year, paying payments during the course of this year based off of last year's liability may not be very appropriate. It may not be the best use of your cash during the year.

Benz: You might end up with a refund which, as you talked about at the outset, that's not an optimal use of your funds.

Steffen: You'd like getting the check, but it's really not the best use of your funds to give the IRS the check earlier.

Benz: In terms of the logistics of paying those taxes, if you are retired you can either take withholding from your IRA distributions, from your Social Security payments, or you can pay quarterly throughout the year. How do you come down on that question for retirees?

Steffen: Once you have figured out what your target is for the year, how much you have to have paid in by the end of the year, you're right, you've got a few options. You can either have that withheld from certain income payments that you get during the year or you can make estimated payments. Not all income from a retiree is subject to withholding. Social Security benefits, you can have taxes withheld on. You can have your advisor withhold on IRA payments or a pension payment you might get from an employer or maybe even deferred comp payments. But things like investment income typically isn't subject to withholding--capital gains, dividends, interest, that kind of thing. Or if you've got some income coming from a rental property or business, like that, you are not going to have withholding on that either.

In those cases, you'd either have to have to more withholding taken from the other income or supplement that withholding with estimated payments. You've got to decide which one is easier, more convenient for you. There's pros and cons to both of those. The withholding is really easy because you tell somebody else, take this amount out of my check, I don't even want to see it. By the time you get it, it's net of withholding, you don't have to worry about paying the taxes. But you are paying that throughout the course of the year, and you are not getting to keep that money for as long as you possible could.

Benz: You are kind of prepaying. If you take your distribution at the beginning of the year, you are taking the whole tax out straightaway?

Steffen: Exactly. For those who take an RMD, for example, right in January, they are paying all that tax upfront. If you wait till December, you are paying it right at the end of the year which may be better, you get to use your cash a little longer, keep it invested, but then you also have to pay some tax during the course of the year, too, especially for those items that are not withheld on. That's where we get into the idea of estimated payments.

While withholding is easy, estimated payments actually give you a better use of your funds in many cases. If you've got large investment income, rental property income, or something like that, you may have to make a quarterly payment during the year. That gets you to keep the use of your cash a little longer, but you also have to remember to make the payment. If you forget, you can always pay it late, but IRS is going to charge you interest from that due date going forward.

Benz: Put it on your calendar. Let's talk about retirees who for one reason or another end up with some big infusion of cash into their retirement plan and kind of managing the taxes around those big payouts. How should they approach that?

Steffen: As we said before, you can pay your taxes based off of your prior year tax liability. Let's say you are a retiree who is plugging along and maybe you are in your 60s or so and you come up on RMD age and all of a sudden, your income jumps up because now you have to take these required minimum distributions. The question is, do you pay the taxes on those RMDs right away or can you wait to pay those the next year? And again, if you are paying off of prior year taxes and you have a spike in income, you can wait to pay the taxes on that spike until you file your tax return.

Same thing goes for retirees who maybe realize a big capital gain from the sales of some stock or a property or something like that. Yes, the gain is taxable, but you don't necessarily have to pay the taxes on that right away. You can wait until you file your tax return. As long as you hit that prior year tax liability target, that 100% of prior year, you will be OK in terms of avoiding a penalty.

Benz: That might result in me underpaying, but the benefit is that I would just pay later on as opposed to paying right off the bat?

Steffen: You might not even be underpaid in terms of penalty calculations. As long as you've got withholding or something else through your other payments that hits that 100% target of last year, this year you can wait to pay that extra tax when you file your return. Now, that may flip itself in that third year when your income comes back down to a normal level. You don't want to pay in based off of that high-income year. Then you've got to be more careful about how your payments are done. Then you've got this other target you can shoot for, which is 90% of your current year liability. In the down year, you had the big income spike one year, the next year income is more level, now you are hitting 90% of that target liability each year. You've got to be a little more careful of that because it requires a more exact calculation.

Benz: Let's talk briefly about RMDs, required minimum distributions. Obviously, a huge topic, but how can I think about managing my tax burden relative to my RMDs?

Steffen: Some people take their RMDs at the beginning of the year and you can have withholding taken out there. That may be a bit of an early prepayment of your taxes. You don't necessarily have to do that. Other people will let the RMDs wait until the end of the year. Leave it in the retirement account as long as possible, get as much tax-deferred growth as you can. Then you take it out in, say, November or December and you have taxes withheld from there. The fear from there that some folks might have is that, well, if I don't pay my taxes till the end of the year am I going to get penalized for being underpaid at the beginning of the year. One of the quirks in this whole penalty calculation thing is that withholding is automatically considered paid evenly throughout the year. Even if you pay it at the very end of the year. So, if you wait to have an RMD in December and you have it all withheld on, then the IRS won't care that it happened in December. They will treat it as if it happened evenly throughout the year. That can be a way for somebody who is maybe behind on their tax payments a little bit, take a little extra out of the IRA, have it withheld on. The IRS doesn't really care when you take it. They treat it as if it came throughout the year. It's a way to catch up for those who may be fall behind a little bit.

Benz: All of this suggests to me that one should get some help in these matters rather than just trying to go it alone, although you may get help from some tax prep software.

Steffen: Certainly, in the first few years as you are dealing with this, once you get into this, retirees tend to get into a routine. Income tends to be pretty consistent from year to year. You kind of get a handle of what your liability is going to be and how much to pay in. Unless you get something like this year where …

Benz: Big changes.

Steffen: … Yeah, your income may stay the same, but your taxes might fall. If you are paying in off of last year's income, you may find yourself, again, overpaid as we said before.

Benz: Last thing, Tim, is how state taxes fit into all of this? We've been talking about federal taxes, but what are the differences with state taxes?

Steffen: The first thing is, not all states have these big radical changes like we've seen on the federal side. While federal tax liabilities may be down, state tax liabilities, they might actually be up in some cases, because while states have lost some of the deductions that we claim on the federal side, they haven't lowered their tax rates in response to that. It's possible you might owe more on the state side.

The second thing is, they have their own rules in terms of what you have to pay to avoid a penalty. There's a lot of correlation between them and the federal rules. They are pretty similar, but not always. The withholding options for state taxes aren't always the same as they are for federal taxes. A lot of IRA custodians or Social Security benefits for that matter, they can withhold federal taxes, but state tax withholding maybe a little trickier. You want to make sure you've got that state tax covered, if not through withholding then through estimated payments.

Benz: Tim, always great to hear your insights. Thanks so much for being here.

Steffen: Thanks, Christine.

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

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Joshua Aguilar: Recently we were able to dig into the topic of 3M's innovation. We've said for a long that 3M benefits from intangible assets, which are byproducts of these innovation efforts. These intangible assets include strong brands, customer relationships, patents, proprietary technology, and other valuable IP. But we had never specifically looked at how efficiently the company was spending their R&D over a cycle, nor how their results compared to other innovative companies.

It's well known that 3M spends about 6% of sales on research and development and the company emphasizes organic sales growth as a key performance indicator to track these efforts. But what we said was knowing these data points is really nice, but a good metric should have both 1) a divisor to track the effectiveness of that spend, and 2) should tally these results over a period of time to get a normalized picture of the company. What we found was that 3M earns about a quarter shy of $9 in returns on research capital over a five-year cycle, which is the amount of gross profit in the current year for every dollar of R&D spent the prior year. We're also predicting this will continue.

What was interesting is that when you compare these results to other innovative companies, not only does 3M spend about 50 basis points more as a percentage of sales compared to a group of 100 innovative firms, their returns on research capital were 57% greater than other highly innovative firms. About 70% of their product pipeline comes from their one-on-one work with customers as opposed to alternatives competitors may typically rely on, like focus groups. While many companies cite customer relationships as a competitive advantage, we think these results lend credibility to the argument that customer relationships really are part and parcel of 3M's wide moat.

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Billy: Fitzsimmons: In expanding our cybersecurity coverage, we recently initiated on no-moat Zscaler, a cloud security name that went public back in March. Zscaler competes with Symantec and Cisco. We think Zscaler has impressive technology, and to understand the value proposition of this business, we need to understand the transitions that are occurring across the software and network security names that we cover.

Years ago, enterprise applications, such as Oracle or even Microsoft Office, sat in the enterprise's data center. Corporate personal computers would connect to that data center to access applications and the enterprise's security stack sat in the data center. That was essentially the drawbridge to access the open Internet.

Today, we are seeing two changes. First, applications such as Salesforce, Dropbox, and now Office 365, are sitting in the open Internet; second, we have an increasingly mobile workforce. Thus, if a regional offices need to access those cloud-based applications, they are no longer in the data center, so there is a muted rationale for an enterprise to continue paying for MPLS technology to back haul that traffic.

Zscaler lets those regional, local, or traveling users get an entire security stack in the cloud to access those applications. Zscaler allows employees to safely and securely access Internet destinations or SaaS applications, while being protected by firewall, advanced threat protection, and sandboxing among others.

Zscaler went public back in March. Their founder, Jay Chaudhry, has founded and sold four network security businesses in the last two decades before founding Zscaler. Even with our 30% compound annual growth rate expectations for this business and modeling solid margin expansion over the next decade, our valuation sits below where the stock has largely been trading post-IPO. We still think the firm has impressive technology and is a burgeoning cybersecurity competitor, but we think the valuation has gotten ahead of itself.

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Erin Lash: Hershey offers one of the more attractive dividends in the packaged foods space yielding north of 3%, and we think further growth is in the cards. Over the past year, Hershey has reined in its spending in international markets, which we view as prudent given we've long thought Hershey does not maintain a competitive edge relative to rivals that have played in these regions for decades.

Hershey is subsequently funneling that spend to support its leading brand mix in the U.S., where it controls north of 45% of U.S. chocolate. While private label threats are minimal in the confectionary aisle, Hershey is not immune to competitive headwinds from both other branded operators as well as other snacking alternatives. And as such, we view the increased investments behind research and development as well as marketing, which we forecast will average around 8% of sales annually over the next 10 years, as a means by which to support its leading brand portfolio, as well as its relationships with retail partners.

The bulk of these assumptions support our forecast for 3% organic sales growth on average over the next 10 years as well as 200 basis points of operating margin improvement to around 23%. These financial results should enable Hershey to generate outsize cash flows. With our forecast calling for free cash flow as a percent of sales to average in the midteens. While we anticipate that Hershey will continue to pursue select acquisitions similar to it's purchase of Skinny Pop owner Amplified late last year, we surmise that returning excess cash to shareholders will remain a top priority.

In this vein, the Milton-Hershey School Trust controls 80% of the voting rights of Hershey sharers. And as a result, we think the firm's commitment of funding its dividend will persist, given the school is dependent on this income to fund its operations. As a result, we expect that Hershey will continue to allocate 50% of it's earnings toward dividends annually, implying around 7% growth on an annual basis over our explicit forecast. With shares trading at more than a 20% discount to our $116 fair value estimate, we think investors would be wise to indulge in Hershey shares.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. A bevy of low-volatility ETFs have hit the market in recent years. But there's significant variations among them. Joining me to discuss some of the key factors that investors should consider when looking at low-volatility products is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: In the most recent issue of ETFInvestor, you wrote about low-volatility strategies, and you put forth a framework for evaluating low-volatility products and I want to get into that. But first, let's talk about the thesis behind low-volatility strategies. Why should investors consider potentially such an approach for their portfolios?

Bryan: The basic idea behind a low-volatility approach to investing is targeting stocks that have historically exhibited low risk. The basic idea here is that these types of strategies are designed to give you a better risk/reward trade-off than the overall market. In other words, the idea here is to offer better downside protection when the market corrects and to still give you some equity upside participation. These types of strategies will likely lag in a strong market environment, but over a full market cycle, you could expect, I think, to earn a better risk-adjusted set of returns than the overall market. You are looking for a better risk/reward trade-off here.

Benz: If I am an investor, say, of a very long time horizon, I know myself to not be risk-averse, so, I don't get spooked when the market is falling or is volatile. Do I have a reason to consider a low-volatility strategy? For whom do you think these products are particularly appropriate?

Bryan: It's really most appropriate for investors who are more risk-averse, who might be more inclined to sell out of their equity positions during a market correction. It's important to have the right expectations going in. These are still equity strategies. They are still going to lose value when the market sells off. But they should hold up a little bit better than the overall market in those tough economic environments. If you are more risk-averse, but you still want to stay invested in equities, I think this is a good strategy for those types of investors. These do tend to provide better downside protection and bounce around a little bit less than the overall market. If you are risk-averse, it could be a good option for you.

Benz: You recently wrote about a framework for evaluating these low-volatility products. Let's talk about some of the key things that investors should have on their radar when they are comparing one low-volatility product, whether ETF or a mutual fund, to another?

Bryan: One of the most important things to start out with is understanding what the selection universe is for the fund, because that's going to have a big impact on the end result in terms of its risk characteristics. Typically, large-cap stocks tend to less volatile than small-cap stocks, and U.S. stocks tend to less volatile than foreign stocks because you don't have that currency risk. If you are looking really to cut risk down, starting with the U.S. large-cap space, that actually might be a really good starting point.

Now, that being said, the performance advantage of tilting toward low-volatility stocks has actually tended to be the largest among the smallest-cap stocks. Now, small-cap low-vol stocks are riskier than large-cap low-vol stocks. But if you are really looking for this performance improvement from tilting toward low-volatility stocks, you tend to get more of that in the small-cap space. It's important to keep your starting universe in mind.

The second point that I think is really important is to understand whether or not the fund that you are looking at is using a holistic approach to portfolio construction or whether it's looking for individual stock characteristics. What I mean by that is, some funds basically target stocks that have low risk characteristics and they don't look at how those stocks interact with each other or what the correlations across those stocks might be. You may end up with a portfolio that's very concentrated in utilities and consumer defensive stocks, for example, because those stocks tend to have low volatility. But there may be risk associated with those big sector bets that you may not get if you were to look at the correlations across those stocks and say, you know what, I don't just want to own the least volatile stocks in the market; I want to construct a portfolio that's expected to have low volatility.

One way to do that is to own stocks that have low correlations with one another because what you really care about as the end investor is the riskiness of the entire portfolio. Funds that use that more holistic construction approach that considers correlations as well as individual stock volatility is probably more appropriate for a core equity position for someone who wants to be better diversified across different sectors and different areas of the market. I think that's the most important thing to look at as you consider these low-volatility funds. That's definitely a good starting point for considering these funds.

Benz: You wrote that some of these funds do have sector constraints in terms of how they are managed. Some of them will say, we don't want X sector to grow larger than X percent or whatever. They might have some rules in place to ensure that they are not overly concentrated in sectors.

Bryan: That's right. And while those sector constraints may slightly reduce the style purity of the fund, we generally view them pretty favorably because certain types of sector bets, especially if you are more risk-averse, may not be desirable, because they are a source of active risk. They are not always going to work out. For example, if I didn't constrain a low-volatility portfolio, I would probably end up with a large weighting on utilities. If interest rates were to tick up more quickly than investors expect, well, that's a source of risk that could hurt those stocks. Maybe I don't want that type of risk in my portfolio.

Generally speaking, if you really are more risk-averse, having sector constraints in place is probably a good thing even though it may cause you to own some stocks of higher absolute volatility than you otherwise might have. I think the benefits from the diversification standpoint offset that downside risk.

Benz: You brought some specific low-volatility ETFs that you like. Let's with the core type large-cap products. Let's cycle through a couple of the ones that you like.

Bryan: One of the ones I really like for core exposure to the U.S. market, again for risk-averse investors, is the iShares Edge MSCI USA Minimum Volatility ETF; the ticker is USMV. What this portfolio tries to do is it tries to construct the least volatile portfolio possible under a set of constraints, which include limiting sectors tilts to the broader market and limiting unintended factor tilts. But essentially, this is using that holistic approach where it's not just looking at individual stock volatility, but it also looks at how stocks interact with each other in the portfolios, the correlations across stocks. This has actually been a wildly successful fund. It's effectively reduced volatility compared to the market index. It's also exhibited much lower downside risk than the parent benchmark. It's actually done quite well, and I think it's likely to continue to provide that attractive risk reduction characteristics going forward.

Benz: There's another large-cap fund that you like AUIEX?

Bryan: That's right. This is the AQR Large Cap Defensive Equity Fund. It uses a similar type of holistic portfolio construction approach. The difference here is that this fund is not just looking at statistical measures of risk like volatility and correlations, but it also looks at fundamental measures of risk like quality. It's looking at profitability, earnings volatility, probability of default. It's looking at these additional measures of quality to supplement the statistical measures of risk and provide a more holistic view of what the riskiness of the stocks may be. That has also been a very successful fund at cutting risk and providing attractive risk-adjusted performance.

Benz: AQR, I know it's a very well-regarded firm, but not the cheapest game in town typically. So, let's talk about that.

Bryan: That's right. This fund charges 41 basis points where the iShares fund charges 15. The difference here, the reason why it's charging a little bit more, is this is an actively-managed fund. It's quant active, so it's a set of rules but it doesn't track a benchmark. The managers have a bit of discretion to determine whether any adjustments to the model are needed or when they want to rebalance the portfolio. There's a few adjustments that they can make to the process. They have been able to recoup their fee at least during the period that the fund has been around.

Benz: In terms of small-cap exposure in the low-vol space, let's talk about a fund that you like there.

Bryan: For investors that are really looking to take advantage of this anomaly where the low-volatility stocks have provided really attractive risk-adjusted performance, you actually get a lot of that juice out of the strategy from the small-cap low-volatility stocks. Now, it's important to keep in mind that small-cap low-volatility stocks are going to be more volatile than large-cap low-volatility stocks. But again, if you compare the performance of the small-cap low-volatility strategy against a broad small-cap index, you will see a better improvement in performance there, at least historically.

One of the funds that I like for exposure to this area of the market is PowerShares S&P SmallCap 600 Low Volatility ETF; the ticker is XSLV. This fund charges 25 basis points. And effectively, what it does is it ranks all stocks in the S&P SmallCap 600 Index based on their volatility over the last 12 months, and it targets the least volatile 20% of the market. Then it weights those stocks by the inverse of their volatility so that the least volatile stocks get the biggest weightings in the portfolio. Now, this fund does not constrain its sector weightings. It does not constrain its turnover. It doesn't constrain anything. It's really giving you a very potent exposure to low-volatility stocks. But because you don't have those risk constraints in place, this is really more appropriate as a satellite holding for someone who really wants to take advantage of this academic effect that's been documented in the literature.

Benz: And finally, a globally-oriented low-vol fund. This one from Vanguard.

Bryan: Vanguard Global Minimum Volatility Fund--this is a mutual fund, but it uses its holistic-type approach that iShares and AQR use for their minimum-volatility funds. This fund is a bit unique in that it is constructing a low-volatility portfolio using global stocks, the U.S. stocks, international stocks, all across the entire market cap spectrum. What it does to further mitigate risk is for the foreign stock portion of the portfolio, it applies a currency hedge. That's an effective way of reducing volatility even further.

One of the benefits of going global with a minimum-volatility approach is that you have more opportunities for diversification. This fund is able to take advantage of low correlations across different markets to construct the least volatile portfolio possible. If you are looking for a one-stop shop for your equity exposure and you are more risk-averse, this is a really compelling option that's pretty attractively priced.

Benz: Alex, always great to hear your insights. Thank you so much for being here.

Bryan: Thank you for having me.

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

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Alex Bryan: Investors hoping to beat the market with index funds have a couple of different multifactor funds to choose from. The case for multifactor funds really boils down to a case for diversification, trying to spread your bets out across several different investment styles that have tended to work over time.

The multifactor fund that you choose really boils down to how much active risk you want to take. Investors who are looking to limit their active factor bets might consider something like Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF, GSLC. This is a fund that takes very modest style bets. It targets stocks that have strong momentum, value, quality, and low-volatility characteristics.

If you are comfortable taking bit stronger style bets, you might consider something like the iShares Edge MSCI Multifactor USA ETF. This fund targets stocks with the best overall combination of factor characteristics, including low valuations, strong momentum, quality, and small size.

These two funds, while they target similar types of factors, look very different. In fact, the Goldman Sachs fund has a low active share of about 27%, whereas the iShares fund has an active share that's closer to 86%. They look quite a bit different and they can perform quite a bit different. The low active share Goldman Sachs fund has lower risk of underperforming, but it also has less upside potential. If you are looking to limit your active risk, that's a good fund to consider. It charges 9 basis points which makes it a very low-cost, compelling option. The iShares fund is a little bit more expensive at 20 basis points, but it's a fair fee for the risk that it takes.

Either way, these two funds are really strong options for investors looking to beat the market, and they both receive Morningstar Analyst Ratings of Bronze.

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Sarah Bush: Prudential Total Return--soon to be renamed PGIM Total Return--is an impressive choice in the intermediate-term bond Morningstar Category.

The fund's appeal starts with its investment team, which won Morningstar's 2017 U.S. Fixed-Income Manager of the Year honors. Managers Michael Collins, Robert Tipp, Richard Piccirillo, and Gregory Peters are an experienced crew. They work with one of the largest research teams in the business which includes roughly 100 analysts. The approach here is rooted in thorough individual security analysis and careful attention to risk. The team's focus on identifying investment opportunities backed by strong fundamentals and healthy income streams has left it with a historical tilt toward corporates. Corporate bonds accounted for close to half the portfolio as recently as late 2015. The team has trimmed this exposure some since then, adding to commercial mortgage-backed securities and other securitized fare. At the same time, the team tends to hold fairly small stakes in U.S. Treasuries and government-backed mortgages. The fund's corporate tilt, a modest-sized allocation to emerging-markets debt, and a willingness to take more interest-rate risk at times than many in the fund's category, can result in periods of volatility. Through the first four months of 2018, for example, the fund's 2.4% loss left it lagging roughly 80% of its peers.

Over the long term, however, the team has put up excellent numbers with top-notch 10-year returns. The fund's many strengths combined with an improving fee profile support its Morningstar Analyst Rating of Silver.