Investing Insights: Social Security, CVS-Aetna, and Fidelity

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Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Many retirees tap their Social Security benefits at their full retirement age or even earlier, while leaving their IRAs until later in retirement. But IRA expert Ed Slott believes that the opposite sequence can make more sense in certain situations. He's here to discuss that topic; he is the author of the newly revised Retirement Decisions Guide.

Ed thank you so much for being here.

Ed Slott: Great to be here, thanks.

Benz: In your newly updated Retirement Decisions Guide, which factors in all of the new tax code, you have a section about Social Security and IRAs and how the two work together. A point you made resonated with me, which was that a lot of investors kind of flip this, where they take Social Security at full retirement age or a lot of them take it even earlier when they are first eligible, and they delay tapping their IRAs. You think there is a reason to consider the opposite sequence, where you delay Social Security receipt and potentially pull from the IRA sooner. Why would that be?

Slott: You have to integrate. When the paychecks stop you have basically these two sources left that people don't work together on, they look at them as separate issues. I have my IRA, and I have my Social Security. I think by now everybody knows with Social Security if you hold off to age 70 you get more. You have the cost of living increases--say 8%--it's like having an account that's growing 8% plus cost of living increases about another 2%, 3%. You could be talking about 10% guaranteed higher checks for the rest of your life if you hold off to age 70. I say if you need the money, take from the IRA during your 60s, if that's enough. If you do need the money it means you are probably in a lower tax bracket, so it won't cost you that much, plus you are bringing down that taxable money, and you'll get a bigger check with Social Security starting at age 70 1/2. I use the 70 1/2 retirement age, for Social Security it's 70, two different things.

Benz: Right.

Slott: At age 70 with Social Security you'll get the higher check for the rest of your life, that's locked in. Now don't wait past 70 because you can't get any more after that. But that's a big deal, because now you have that guaranteed highest check for the rest of your life, and at worst Social Security is only taxed--I say only--85%, it sounds like a lot. But IRAs are taxed 100%. I'd rather have the money that's less taxed, more of that going into retirement.

Benz: Are there any obvious situations though where that sequence of potentially tapping the IRA first and delaying Social Security receipt, where that doesn't make sense. Any sort of profiles of individuals?

Slott: I think it's more psychological. Once you are eligible, people want that money. I know people in my own family, I have said don't do that. No but why would I give that up, that's another year I didn't have money for that. It's just why would I give up something I could have now to have more later. Remember when you are talking about retirement planning you are talking about even at age 70, people live to 90, 100 years old. The great thing about Social Security benefits other than savings account, like an IRA, I call Social Security like renewable resource--it never runs out. You spend it, it comes right back next month, you spend it, it comes right back next month. It's guaranteed income for life. Not, so with a savings account. Sure, you could draw from a savings account, but you could draw it down. Also if you draw from a savings accounts--and I include retirement account--you have the tax of course. If you are withdrawing in a declining market then you have what's called that sequence of returns risk where you really start losing boatloads of money, that you can't make back in retirement because you have no more paychecks. If you need money in those years in the 60s once you reach full retirement age or even before you could take it, there are penalties, but then take the money. You don't think you are going to live that long. You have health issues. There are reasons, everybody has a different situation. But all things being equal--you are healthy, you can live on the IRA during your 60s--you are generally better off waiting till age 70 to start drawing on the highest Social Security check for the rest of your life.

Benz: You mentioned sequence of return risk which is such an important concept in the retirement planning space, and that basically means that you encounter that lousy market environment right out of the box when you retire. Is there potentially a risk for retirees today? We don't want to get into market timing, but the market has been going up for the better part of 10 years.

Slott: There is something called gravity.

Benz: Right. So realistically this …

Slott: It's all timing, nobody knows. Look at people who chose to retire, because it was their time in 2008. They retired at the worst possible time, when the market was in free-fall. That is not the time you want to start drawing from investments in a market you can never recover. So yes, then that equation shifts. You might be better off leaving that money, the money invested in the market, leave it there to rebound and take the Social Security if you need it. Just so you don't have to touch money in a falling market.

Benz: Or at a minimum perhaps line up some more conservative investments within that IRA so that you are leaving your equity holdings to recover.

Slott: Right.

Benz: Ed, thank you so much for being here. An important topic, thanks for discussing it with us.

Slott: Thanks.

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

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Vishnu Lekraj: Late last year, CVS and Aetna announced they were going to merge into a large healthcare services conglomerate. There has been much talk in the market about this new firm, how it will flow, and what the moat implications will be for the company ultimately.

After analyzing the deal and looking at it from the perspective of healthcare servicing in the U.S. moving forward over the next several decades, we believe this company will be a powerful player within this space. We believe it will command a lot of pricing power and a lot of leverage within the market that will give it some cost advantages over its peers, such as the managed-care firms, the PBMs, and retail pharmacies.

We believe the new company will be a powerful player moving forward within the U.S. healthcare market, and it currently makes CVS a great company to own as it's undervalued and has some great competitive advantages.

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Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Fidelity recently announced that it's slashing investment minimums and lowering costs on number of its funds in some cases all the way down to zero. Joining me to discuss the news is Ben Johnson, he's director of passive research strategies at Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me Christine.

Johnson: Ben, let's talk about some of the headlines here, there was a lot of news released by Fidelity yesterday. Let's talk about some of the key things, some of the key changes that they're making especially to their index lineup.

Johnson: The headline without a doubt was that Fidelity is launching a pair of zero-fee index mutual funds. Those funds will be underpinned by Fidelity indexes. They'll have no investment minimums, I can walk up to a Fidelity branch with $1 in theory and invest in one of these funds with an ongoing expense ratio of nothing.

Benz: There is Total U.S. Market Index and a Total International Index, is that right, those are the ones going to zero?

Johnson: Two broad-based market-capitalization-weighted equity indexes. One covering the whole of the U.S. stock market, one covering the rest of the world.

Benz: Then across the lineup they are doing some reduction in fees and also removing minimums from a whole lot of funds.

Johnson: While the zero fee index funds captured all of the headlines, what I would argue is that the nipping and tucking across Fidelity's existing index mutual fund lineup was far more economically significant, certainly for existing shareholders which will now enjoy the lowest pricing available, irrespective of how much they have invested in the fund, irrespective of which share class they're invested in today. Those share classes will ultimately be collapsed into one. The investment minimums on those share classes has also been reduced to zero. I think this is a very beneficial move that opens up institutional level pricing for even the very smallest investors.

Benz: One headline you think kind of got lost in the shuffle was the fact that the firm is expanding its commission-free ETF lineup.

Johnson: That's right, there are so many different bullet points in this announcement it's difficult to keep track of them. I think one that got buried quite deeply was the fact that it's commission-free ETF menu has now expanded from 95 ETFs previously to 240, the bulk of those being added at the margin being iShares ETFs. What you see in sum, is really to put it in its context is a competitive response on Fidelity's part. What we saw if we go back to February of last year is that Schwab made similar moves within its own index mutual fund lineup, repricing a number of those, reducing investment minimums across the board to offer a far more compelling offering that's available to a far larger number of its investors. Schwab's also over the years been gradually expanding its own commission-free ETF menu. More recently what we saw is that Vanguard effectively opened the floodgates on its proprietary commission-free ETF menu offering virtually any ETF that investors on their platform could want to trade on the commission-free basis that's effective as of Aug. 8 of this year.

Benz: The question is--and you've alluded to the fact that there are these huge competitive pressures within this ETF and indexing business--do you think other firms will follow Fidelity down to 0% expense ratio?

Johnson: It's certainly been the case, is that we've seen these frogs leapfrogging one another, headed into, I don't know, a boiling pot of water, at least as is perceived by many as we've gone ever nearer zero with respect to fees on index mutual funds. It'll be interesting to see if predominantly either Schwab or Vanguard respond in kind. I'm most eager to see what the competitive response might be from Vanguard. If you look at the firm's index mutual fund lineup today and the share class structure an the investor share class in particular the minimum investment requirements there and the fees in particular are looking out of step when you consider it in the context of what Schwab and Fidelity have done within their own index mutual fund lineups.

Benz: The minimums are higher, maybe $3,000?

Johnson: $3,000, $10,000 in the case of the Admiral share class. But the fees on that investor share class is in some cases multiples higher than what you might pay for a comparable exposure from one of Vanguard's competitors.

Benz: Let's talk about what's in it for Fidelity, it sounds like keeping up with its competitors was top of mind behind these moves. What does Fidelity stand to gain from the fact that it's going to have some funds on its racks that are essentially loss leaders?

Johnson: What Fidelity's clearly gotten from all of this is loads of great press, free press. That 0% fee headline has been pasted over just about every publication imaginable. We're here talking about it ourselves. It's attracted a lot of attention. And rightfully so, because a zero-fee fund broadly diversified market-cap-weighted indexes in the U.S. and outside, this is inarguably a great thing for a huge number of investors, because the investment minimum is also zero. But economically from Fidelity's point of view this, I would say, is absolutely a loss leader. It's the gallon of milk that's in the refrigerator at the back of the store and Fidelity is counting on the fact that once you walk in and start touring the aisles with your cart that you are going to walk out with more than just a gallon of milk. That you might look at their active mutual funds, that inevitably you might have a cash sweep into one of their money market funds.

Benz: Which are profitable, right?

Johnson: Which are now, I would assume, profitable after many years of having to be sort of subsidized given the low interest-rate environment. For a number of years now, money market funds have kind of been the asset management equivalent of the boomerang Millennial that comes back to live in mom and dad's basement and raid the fridge every now and then. As interest rates have risen, the money market business has become money-making business again. The timing may be purely coincidental, or it may reflect the fact that Fidelity has more wiggle room from an economic point of view to afford to offer these loss leaders at this point in time.

Benz: Fidelity has some pretty good active bond funds as well. That seems like one category where investors haven't completely lost faith in active management is in fixed income.

Johnson: Absolutely the case.

Benz: Let's talk about what's in it for investors. Obviously low fees are good, they are something we want to see, but I guess the question is, investors are paying fees somewhere. It seems that advisors are increasingly taking some of the fees that heretofore had gone into funds. Is something getting lost in terms of accountability and transparency? Let's talk through the positives and the negatives for investors.

Johnson: I think it depends on the investor in question. A self-directed investor that's perfectly comfortable building a simple portfolio for themselves, this is an absolutely fantastic thing. They can do so for now if not nothing next to nothing. I think if there is any real impact that this move will have its psychological in nature in that investors are now coming to expect to pay nothing for broad market exposure, no different than we don't expect to pay to have a checking account. We don't expect to pay for WiFi when we sit down in our local Starbucks …

Benz: In hotel lobby or …

Johnson: Hotel lobby. That's very meaningful. If you zoom out and look more broadly at what we've seen in terms of flows in recent years and the trillions of dollars that have gone into low cost funds of all sorts be it index based or active, this is really reflective of a shift in the economics of advice. There are other investors that are working with an advisor. And those advisors' economics are changing with time as well moving from transaction-led models to fee-based models.

I think of it as sort of a squeezing of the balloon. The air is not being let out of the baloon and it's just going from one segment to another. What's getting squeezed is the cost of the investment products that advisors are using on behalf of their end clients so as to be able to preserve that fee where they earn their keep, how they keep the lights on, how they pay their bills. Now to the extent that those fees might not be uniform, they might not be transparent, you might not be able to compare them as readily as you would fees for investment products--indexed mutual funds, ETFs, funds of all sorts. This can be somewhat concerning, so I think it's important that investors in that context when they're working with an advisor ask some tough questions about how much am I paying you, how am I paying? What am I paying you for?

Benz: What does it look like in dollars and cents I always say.

Johnson: Absolutely. While we certainly need to celebrate the fact that cost of the investments that we're using or an advisor is using on our behalf are drawing ever nearer zero and have hit zero, in pair of cases, it's important to understand that there are other expenses out there that we're going to incur and not to forget the tyranny of compounding costs and what they can do to our overall outcome as investors.

Benz: Ben great insights as always. Thank you so much for being here.

Johnson: Thanks for having me.

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

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Connor Young: Silver-rated Parnassus Core Equity and Neutral-rated Parnassus Endeavor have much in common. The managers--Todd Ahlsten and Ben Allen for Parnassus Core Equity and Jerome Dodson and Billy Hwan for Parnassus Endeavor--seek firms with sustainable competitive advantages, relevant products, capable management, and ethical practices. Management buys with conviction and tends to hang on for the long term; indeed, both funds hold just 30 to 40 names and have below average portfolio turnover.

Despite the similar approach, the funds have distinct portfolios. Parnassus Core Equity has a clear quality tilt, which has helped protect against losses in down markets and dampen volatility. The fund has a Morningstar Risk rating of low. By contrast, Dodson and Hwan are less willing to pay up for quality in Parnassus Endeavor; they purchase only stocks trading at a

discount to intrinsic value. They'll also build larger positions in high-conviction ideas. While holdings in Core Equity are capped at 5% of assets, Qualcomm and Gilead Sciences each comprised more than 10% of Endeavor's June 2018 portfolio. Dodson and Hwan's contrarian approach means Parnassus Endeavor can be an uneven ride; the fund has an above average Morningstar Risk rating.

Both funds receive positive process ratings, but greater conviction in Parnassus Core Equity's management earns it a higher Morningstar Analyst Rating.

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. At Morningstar, we're fans of companies that have wide economic moats. Such high-quality firms have competitive advantages that allow them to effectively fight off competitors. Several funds pursue strategies targeting high-quality stocks. Here are three good funds holding substantial positions in wide-moat names.

Tony Thomas: The managers of Mairs & Power Growth aren't your typical go-go growth investors. Their favorite companies offer steady, sustainable growth over time. That often means managers Mark Henneman and Andy Adams are investing in established companies protect by wide moats.

For example, one of the fund's largest holdings, US Bank, enjoys cost advantages and regional dominance. Another top holding, 3M, uses its research prowess to develop new products and protect them with patents, fortifying its numerous competitive advantages. Such advantages don't always show up in financial statements, and the managers often get their best leads looking in their own back yard.

Keen observers will note that US Bank and 3M are based in Minnesota, not far from Mairs & Power's St. Paul offices, and that's no fluke. This level of access helps give the managers the confidence to buy and hold their best picks. This long-term approach built on wide moat companies contributes to the fund's Silver rating.

Robby Greengold: The Polen Growth Fund uses a highly disciplined investment process designed chiefly to protect shareholder capital. Portfolio managers Dan Davidowitz and Damon Ficklin take a long-term perspective as they hunt for financially superior and competitively advantaged businesses.

This is a concentrated portfolio holding only about 20 stocks. The managers are essentially looking to buy the best companies in their investable universe. They like companies with juicy margins, strong organic revenue growth, an immaculate balance sheet. Since they want to own these stocks over the long haul, they want to see wide competitive moats.

What you'll see a lot of in this portfolio are firms benefiting from network effects and possessing high switching costs. Adobe and Microsoft, for example, which have been top holdings recently, arguably fit that profile. What you probably won't see a lot of, or any of, are commodity-like industries, highly levered or highly regulated businesses--so no telecom, no energy, and sparse holdings of financial stocks.

This is a Bronze-rated fund. It's unique, and we continue to have a lot of confidence in it.

Greg Carlson: Jensen Quality Growth is a fund that invests in a lot of wide-moat stocks. Its managers have stringent criteria. They're looking for companies that have generated returns on equity of at least 15% over each of the previous 10 calendar years. That results in a universe of roughly 100 to 200 companies, so it's a pretty narrow investment pool.

These companies tend to be very steady with very little debt and very strong competitive positions. As a result, the fund has one of the highest exposures to wide-moat stocks in the entire large-growth category; it's generally in the top 1%. Over the long term, this has meant muted volatility and excellent risk-adjusted returns, although the fund can lag during big rallies.