Investing Insights: Fund Laggards, RMDs, and Housing Sales

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. It's the fourth quarter and that means it's required minimum distributions season. Joining me to share some tips and traps for RMD taking is retirement expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Thanks, Christine.

Benz: Well, it's the fourth quarter and it's required minimum distributions season. I know a lot of our viewers are subject to RMDs. I wanted to walk through some of the rules and also some of the traps that you see people falling into. Let's start with just, kind of, the basics of RMDs--which accounts are subject to required minimum distributions and who is subject to RMDs.

Slott: Well, RMDs, required minimum distributions, most seniors know them well. That's the time after age 70 1/2 they're forced to take the money out, whether they want to or not and add to their tax bill. IRAs are subject to RMDs, so are most company plans; Roth IRAs, your own, are not.

Benz: That's the one exception. Roth 401(k) though sometimes …

Slott: Are, because they are part of a 401(k). But there's an easy way around that. If you are approaching age 70 and you're still working, you have a Roth 401(k), just move it over to your own Roth IRA before the year you turn 70 1/2 and that will stop that. Because now that it's in your own Roth IRA, there are no required minimum distributions if your plan lets you do that.

Benz: One cohort who potentially is not subject to RMDs is the people who are still working in retirement at 70 1/2, and they have those company retirement plan assets. Those assets are not subject to RMDs, correct?

Slott: Maybe. That's where you see lots of mistakes. This is one of those areas where, I always say the law of the plan is the law of the land. This is one of those areas, as complicated and technical as all these tax rules around IRAs and plans are, the tax rules themselves are actually more liberal than what the plans have to allow. They don't have to allow it. Now, lots of plans allow what we call this "still working" exception, which means, if you are still working after 70 1/2, you can delay--in the plan, if they allow it, the tax rules absolutely allow it--if they allow it, you can delay your required minimum distributions from that company's plan, the company you are still working for, until you retire.

But here is the mistake. First, not everybody qualifies. Basically, if you are self-employed, you can't do this in your own plan. There's what's called a 5% rule. If you own more than 5% of the stock, as most self-employed people do, you can't do it.

Benz: Okay.

Slott: But a regular employee from big companies doesn't own 5% of IBM or something like that. But here is the mistake. People that this applies to, they think it applies everywhere. The exception or the deferral only applies to the plan of the company you are still actively working for. If you have other 401(k)s, you still must take from those. This rule never applies to IRAs. You still must take from those. Remember, with a required minimum distribution, if you are short or don't take it, it's a 50% penalty on the amount you should have taken but didn't. So, yes, you might qualify for this exception but it's only in that company's plan, no other plans.

Benz: Let's talk about the calculation. It's fairly straightforward. You look at the right table and calculate how much you need to take out.

Slott: I'm laughing because you threw in, to assume you looked at the right table.

Benz: Let's start there. Because there are a couple of tables that one could look at. You say that you have encountered people who have made some calculation errors. Let's talk about how to keep yourself straight in terms of taking out the right amount.

Slott: Well, it is kind of easy. IRS gives you three tables; two could apply to you, most people just one. It's the Uniform Lifetime table. You can get it in IRS publication 590-B and they have all three tables. Now, for an odd situation, or maybe not that odd, if your spouse is your sole beneficiary for the entire year and that spouse is more than 10 years younger, you can go to the expanded joint table and get a little better break. That's a separate table. But other than that exception, everybody uses the Uniform Lifetime table. The Single Life table, that third table, is only for beneficiaries. Never use that.

Benz: Say I have multiple IRAs, which is very common, I have a lot of accounts, do I total them all up and then put them through one of those tables? How does that work?

Slott: Yes. This is where things get a little …

Benz: The aggregation.

Slott: Yeah, the aggregation get a little confusing. IRAs have what's called an aggregation rule, which means, just as you said, people have a bunch of IRAs. Under the tax law, you only have one IRA. Even if you have 10, it's all considered one. Under the tax rules, you can take your required minimum distribution. First, you figure out the RMD from all of your IRAs and whatever that total is, you can take it from any one or a combination of those IRAs. But you can't take it, say, from a 401(k) or a 403(b), you can't use another account to satisfy the RMD from a different type of account.

Benz: Let's talk about some of the other traps that can crop up in the RMD space. One thing I sometimes hear from our Morningstar.com viewers and readers is, I have this RMD and I don't need it, so I'm going to put it into a Roth IRA.

Slott: Yeah, it's up there with the top questions. You know why it's a good question? Because it's logical, but the tax law isn't logical. I have had people that tell me, I took the money, I paid the tax, isn't that all they want? Why can't I put it in a Roth? It's already bought and paid for. Because you can't; because the tax law says, at rollovers--required minimum distributions cannot be rolled over; otherwise, the money would never get out. And a conversion is considered a rollover. The RMD must first be taken and that money cannot be converted. But then you can convert other money once the RMD is satisfied, and if you want, the money you took out that you can't covert, you can use that to pay the tax on other monies you can covert.

Benz: But I could potentially take out my RMD and assuming I'm still working, I could fund a Roth IRA, that's right, right?

Slott: Right, because there's no age limit on who can contribute to a Roth IRA, but there is an income limit. So, you have to look at that.

Benz: Even if I'm not working but my spouse is working, we could make an IRA contribution up to …

Slott: Right, but the spouse has to qualify other than having earned income.

Benz: One thing that you say is going to be really important for a lot of retirees this year is what's called a qualified charitable distribution. Let's talk about that and how RMD-subject retirees can take advantage of that maneuver and why they may want to consider it.

Slott: Well, every person that gives to charity should only be doing it this way. The only thing bad about the qualified charitable distribution or QCD is that it's not available to everyone. It's only available to IRA owners or beneficiaries who are 70 1/2 or older. If you are 70 1/2 or older, you have an IRA, you are taking your RMDs; if you also give to charity, what you should do is do the QCD, which is a direct transfer from your IRA to the charity.

What that does, it's excluded from income, and the amount you give to charity goes toward satisfying your RMD and you can do, if you want to, up to $100,000 per person, not per IRA, per person, per year. You are excluding that income. That's the same as getting a deduction, but it's better than a deduction, because you are reducing your adjusted gross income, which is a key number on the tax return. Now, you don't also get the charitable deduction because that would be double dipping.

Benz: Let's talk about what about 2018 and the years that follow make the QCD particularly attractive. It's that many fewer people will be itemizing their deductions?

Slott: That's right. You may be giving to charity and you will realize when you do your tax return, I'm not even getting the deduction, because most people under the new tax law for 2018 will be using the new higher standard deductions. They won't get the benefit of the charitable deduction. If you use the QCD, you get the new higher standard deduction and in effect, the charitable deduction; now, I say, in effect, because you are not getting a deduction, but reducing or excluding it from income is the same as a deduction. You get that plus the big standard deduction. Everybody should be using it who qualifies.

Benz: If you are charitably inclined at all. And you might hear $100,000 and think, oh, I need to be a high roller. If I'm writing a $200 check, I should consider …

Slott: But you know the question we get: Somebody has a required minimum distribution of $5,000, let's say, but they normally give $7,000 to charity. You can give more than the RMD. The first $5,000 satisfies the RMD and the other $2,000 is also excluded.

Benz: Ed, valuable advice. Thanks so much for being here.

Slott: Thanks.

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

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. We all have a laggard holding or two in our portfolios. Joining me to discuss how to evaluate laggards 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: Russ, in the latest issue of Morningstar FundInvestor, you talked about how some funds have lagged recently and how to go through your portfolio and make a reasonable assessment about whether they are worth hanging on to because they will come through the performance slump or whether you should just cut them loose.

Let's start with a really basic question. Sometimes people look at their portfolio holdings and see funds that have way underperformed either the market or their peer groups and just decide to cut them loose. Is that a good approach?

Kinnel: No, it really isn't because you really need to understand the fundamentals, you need to understand why you own the fund. And you have to understand, too, that every fund is going to underperform, especially if it's a focused fund. So, therefore, you need patience and you need to really understand why the fund is underperforming. It's really dangerous to simply throw everyone overboard that underperforms for a year or two.

Benz: Say, I have a holding in my portfolio and it has way underperformed its category peers, maybe even over a five- or a 10-year period. What are the steps that I should take in doing my due diligence about whether this is something worth hanging on to?

Kinnel: I think you want to understand are there new problems that this slump highlights or is it more the case that maybe their strategy is out of favor. The markets tend to favor certain sectors, certain strategies and therefore leave other ones out of favor, yet those same strategies can come roaring back very quickly because the markets rotate, they correct. You want to see is the fund really continuing to do what it's supposed to do, are all the key people there. If all the key things are in place, you probably want to stick with it. Because again, the markets can rotate very quickly. And if you sell all of your losers, you may end up with next year's losers instead.

Benz: How about on the flip side? What are things that, if you are looking at a fund that has lagging performance and it also has X, Y, and Z problems, what are the things that you consider red flags?

Kinnel: It starts with people. Is the fund losing key managers or analysts. And then, I think, it's about process. Has the fund's process changed? And then, even things like fees. Sometimes underperforming funds will get a lot of redemptions and then all of a sudden, their fees are rising. And so, you do have a fundamental change. Maybe it's not necessarily their fault, but anyway, now you have a higher-cost fund and that reduces the odds of it coming back strongly.

Benz: This is a due diligence process that you and the team go through when deciding funds' ratings. Let's talk about a couple of recent examples of funds that have been under scrutiny because performance has been poor. Let's start with AMG Managers Montag & Caldwell Growth. This is a fund that the team recently downgraded. Let's talk about the factors that affected that downgrade. Its performance has been weak, but what else was going on there?

Kinnel: That's right. The performance has been weak and some of that we can attribute to a high-quality bias which for the most part in the last few years hasn't worked that well. And we could cut it some slack for that, but the fund has had some personnel changes. The lead manager is set to change at year end. So, that's a pretty big deal. And also, we saw fees are rising. As I mentioned, because assets are flowing out of the fund, fees are rising at a time other funds are getting cheaper and cheaper. So, the bar is getting raised, as it were, by lower fees. And so, you do have two fundamental deteriorations at the fund that give us a concern and have led us to lower the rating to Neutral.

Benz: This is a fund that had been a medalist but now it's down to Neutral because of the factors that you mentioned?

Kinnel: Exactly.

Benz: Let's talk about another growth-oriented fund, ClearBridge Aggressive Growth. This is one that also has had weak performance, but the team has maintained its Silver rating. Let's talk about the things that keep us liking the fund despite the weak performance.

Kinnel: This fund is a little bit quirky. And so, I think, to own a quirky fund you really have to accept those quirks from the beginning. And in this case, Richie Freeman is a very low turnover investor. Typically, turnover runs like 1% or 2%. It's even lower than an index fund …

Benz: Which is not something you often see with growth-leaning funds.

Kinnel: That's right. Very patient manager. If you look in the portfolio, there are names that go back 20 years or more. One of the issues today is that the fund doesn't have some of the FAANGs and some of the other really hot stocks because, again, it changed the portfolio very slowly. And so, some of the time those names are going to be out of favor with the market. And that's what's happening today.

Benz: You did a deeper dive into a number of other funds that have recently had disappointing performance, so people who are interested in reading about those, can go ahead and see the latest issue of FundInvestor.

Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

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

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Andrew Bischof: U.S. electricity demand has flatlined during the last decade, but we think it is set to spring to life. Energy efficiency will remain a drag on electricity demand, but those gains face diminishing returns. We think three emerging electricity demand sources--electric vehicle charging, data centers, and cannabis cultivation--will approach 6% of total U.S. electricity demand by 2030, offsetting energy efficiency and supporting our 1.25% annual electricity demand growth forecast through this time period.

Utilities will have to work hard to benefit from these new demand sources. The most successful utilities must attract these industries by investing in grid expansion, smart networks, safety, reliability, and renewable energy during the next decade. Utilities that slack on investment now could face slowing earnings and worse, dividend growth. Worst case, utilities that miss out on this new demand might face the so-called death spiral, leaving investors with disappointing future returns. We highlight three utilities that should benefit from our forecast.

Wide-moat Dominion energy's usage based distribution rates at its utility are a positive, given our projection that electricity demand in the state will grow nearly 2% annually over the next decade. Virginia regulation is also more constructive than average for investors. Dominion's service territory is also positioned on top of data center alley, providing a significant electricity demand boost.

Duke relies primarily on usage-based rates, which we expect to be a positive since its service territory covers states with above-average electricity demand growth. Our long-term demand growth forecasts for North Carolina, South Carolina, and Florida are higher than the national average. Duke also benefits from regular, constructive rate decisions in Florida and a supportive regulatory environment in the Carolinas. Continued demand growth could add more growth opportunities to Duke's already robust capital plan.

Edison's decoupled rate structure makes it one of the few U.S. utilities that have no direct exposure to demand. That should be a relief to investors since we forecast California will have the slowest electricity demand growth in the country during the next decade. In fact, Edison could benefit from keeping this growth down because of the energy efficiency incentives it can collect. Edison could also benefit from more grid investment to integrate distributed generation. Finally, Edison should benefit from investment opportunities related to California's progressive public policies on electric vehicles and cannabis use.

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Highly rated funds aren't always chart-toppers. They can slump if their styles fall out of favor relative to their peers. Today, we are taking a look at three funds that earn Morningstar Analyst Ratings of Gold whose year-to-date returns land near the bottom of their respective categories.

Katie Reichart: Gold-rated Oakmark Fund is in a slump this year, but investors shouldn't count it out. The fund is down 2.5% for the year to date through November, while the S&P 500 is up 5%. There are a few reasons for its underperformance. GE is undergoing a restructuring under a new management team, and it's lost over half its value for the year. Some detractors are names the managers have bought in the past year, so they might have been a bit early on them, including Flex and DXC Technology. Other holdings are financials names that fund has owned for a long time that have done well at other points but are doing poorly this year, such as AIG and State Street. The fund has typically underperformed for stretches but it's always rebounded strongly, including after rough patches in 2008 and 2015. Manager Bill Nygren is experienced and is sticking with his long-term mindset, and so are we.

Maciej Kowara: Western Asset Core Plus Bond Fund is a Gold-rated fund that has had a fantastic run after the financial crisis, but 2018 has proven difficult for it. The fund is underperforming its benchmark and the majority of its peers this year. There are two reasons for this underperformance. One is long duration; two is emerging markets. The fund has long been using long duration partially as a hedge against problems developing in risk assets of which emerging markets are one. Emerging markets, on the other hand, looked attractive from the valuation standpoint and from the reading of the global economy, at least at the beginning of the year. Now, what happened this year is that that hedge failed to work. Treasuries are down, and emerging markets are down even more. Nonetheless, we still have full confidence in the fund and believe that investors who stick with the fund for the long haul will be amply rewarded.

Alec Lucas: Gold-rated American Funds New Economy's year-to-date 2018 performance is a reminder of the fund's risk profile. The fund is nearly global in its pursuit of innovative companies and it invests broadly across the market cap spectrum. It's not uncommon for the fund to invest 60% of its assets in U.S. stocks and most of the remainder overseas in Asia. That kind of profile was a big help to the fund in 2017 relative to the Morningstar large-growth category. But it has hurt the fund thus far in 2018. Top 10 holdings Samsung, Galaxy Entertainment Group, and Tencent have all hurt the fund in 2018. But relative to the MSCI All Country World Index, the fund's results remain competitive and even superior. It remains a very good fund long term for investors who understand its risk profile.

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Emory Zink: The intermediate-government bond category may appear straightforward, but its constituents offer subtly differentiated portfolios. For example, both Silver-rated JPMorgan Government Bond and Bronze-rated American Funds US Government Securities are funds with Positive Process Pillar ratings. While the investment menu for either is similar, and includes U.S. Treasuries, agency mortgages, and more modest allocations to out-of-benchmark fare, such as TIPS and CMBS, the funds' profiles can differ considerably.

For example, JPMorgan Government Bond selects collateralized mortgage obligations, or CMOs, which the team prefers for their stable and predictable cash flow characteristics. As of September 2018, the allocation to agency CMOs was 35% for JPMorgan Government Securities but only 3% for American Funds US Government Securities, which prefers more traditional agency mortgage pass-throughs.

While American Funds US Government Securities keeps its duration within a year of its Bloomberg Barclays U.S. Government/Mortgage Index benchmark, JPMorgan Government Bond explicitly maintains a duration within a corridor of five and five and a half years.

Another difference is that JPMorgan Government Bond will use more exotic mortgage derivatives, such as IO and inverse IO, modestly at times. American Funds US Government Securities doesn't employ those in its buttoned-up portfolio.

In flights to quality, both of these funds should benefit relative to more tempestuous peers, but as their portfolios indicate, they are not identical intermediate-government bond options.

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Brian Bernard: So far, in 2018, housing demand has slowed relative to last year. While rising home prices and higher mortgage rates have made homeownership a less compelling investment for some and might have completely priced out others from the housing market, especially in high-price markets like in California, we do think that there's other factors involved. We think a tight supply of existing home sales, which is particularly acute with more affordable homes, has really driven that year-over-year decline in existing home sales. Now, it's generally believed that that market is balanced when there's six months' supply of existing homes for sales; as you can see, we are at four months. So, we are undersupplied.

And then, just to touch briefly on the new construction, so that's the starts, the sales, we're up year-over-year but that has slowed. Aside from demand some things that could be slowing it, too, is: there's a tight supply of labor. It's taking longer to build homes and it's taking longer to get entitlements from municipalities. But the hot topic is affordability. And the question is, with the rising mortgage rates and the high home prices, have we hit a breaking point? We don't think so.

We like this chart here to show affordability. So, it is the median mortgage payment to gross income. We think that's a good way to assess affordability. Now, it's not going to be indicative of all housing markets, but it's good for a national level and that's below long-term average. So, we are still good there. Affordability is good by that metric. The fact of the matter is, mortgage rates are rising, but they are still historically low. We're seeing wage growth that's offsetting the higher home prices, and we continue to expect more wage growth and we do expect homebuilders to put out more lower-priced products. So, affordability should stay in check over next decade.

Now, we are bullish on our long-term housing outlook. Why? We do think we are going to see some demographic tailwind from the millennials. As you can see, the millennials, that's a quarter of the population, hitting that prime age for homeownership. Now, the question is, do these guys even want to buy homes. You will see that a lot in the media. But we've done a lot of work, reviewed a lot of surveys, and the fact of the matter is, is that we think that that this generation still aspires to own homes.

In terms of our housing forecast, starts is the blue line, is the historical and our forecasted. Now, we did take a step back, took a fresh look at our underlying assumptions and took into consideration some of the fresh data that's been a little bit weaker than we expected. We did reduce our long-term forecast. We now expect 15 million starts between now and 2027, peaking at 1.6 million. That's about a 10% reduction over our prior forecast. But that's by no means a bearish call. We still expect seven more years of strong residential construction.

Now, we don't think that this is an overly optimistic forecast either. I want to point to this slide, homeownership rates. Now, looking at this younger age cohort, the millennials, so we are showing--this is the historical 2017 and our projection--we are showing some modest improvement there. That's what's driving a lot of demand. But when you look at the overall population, we are projecting 65% homeownership rate. That's well below the long-term average. So, we still think we are being conservative.

Getting back to the forecast here, we do have a couple of scenarios for you. The bull case, that's the green line, that's getting back to about 1.9 million starts. That's getting close to the peak. What do we need to get there? We need strong wage growth. We need loser credit standards, because it is difficult to get mortgages for some. We really need homebuilders to really start pushing out those entry-level homes.

Now, on the flip side, the red line is the bear case scenario. That's saying, hey, we are at about 1.3 million starts, that's as good as it gets. Affordability is going to worsen. Credit standards might get worse. Homebuilders aren't going to build anymore. That's really the assumptions there. Just what you are seeing with the homebuilder stocks and whatnot, we think more of the consensus is more leaning toward this path. But based on all of our work, we are still confident that yellow line, the base case, is the most reasonable outlook. If that's the case, if we get back to 1.6 million starts, that's good for the U.S. homebuilders, that's good for the U.S. building product companies, and a lot of those stocks have been beaten down.