You've worked hard all your life, diligently saved a portion of your earnings along the way, and invested that money wisely. You've built a nice nest egg to help provide for your family in your later years. Congratulations. That is quite an accomplishment!
But what now? How should you continue to invest this money at a time of life when you may no longer have a paycheck coming in? How much, if any, of the principal can you use for living expenses? How can you make sure the money will last as long as you do? These are important questions, and the "usual suspect" often rounded up as the answer — an annuity — is far from perfect.
A new possible answer arrived on the scene about six years ago. Commonly referred to as "managed-payout funds" (also called "income-replacement" or "retirement-income" funds), this new breed of mutual fund was designed to offer some of the benefits of an annuity without the major drawbacks. But managed-payout funds are not without problems of their own. Let's take a closer look to see if they may be a viable vehicle for helping you turn your retirement nest egg into an income stream.
The problems with annuities
Annuities certainly sound appealing. What retiree wouldn't want guaranteed income without having to manage the investments that generate that income? Ah, but there's a catch. With annuities, peace of mind comes at quite a cost. (See Making Sense of the Annuity Puzzle for a primer on the pros and cons of the various kinds of annuities.)
First, there are fees involved. Of the core types of annuities on the market — immediate or deferred, fixed or variable — SMI generally recommends that only older investors consider an immediate-fixed annuity. With that type, you use a portion of your nest egg (and we never recommend using any more than a portion) to purchase an annuity that immediately begins providing a guaranteed (fixed) amount of income.
For those who go this route, we also recommend buying such an annuity directly rather than through a commissioned salesperson. Still, there are relatively hefty fees involved. For example, if you buy an immediate-fixed annuity from Vanguard, you will pay a fee amounting to 2% of the purchase price. Buy a $100,000 annuity, and only $98,000 of your money will go to work generating income for you.
Even more importantly, once you commit to an immediate annuity, there's no going back. You lose the flexibility to access those funds in an emergency, or to transfer them to another investment vehicle that may have become more attractive.
In addition, under a single-life annuity, the income option that pays the most each month, when the annuitant dies, the income stops. Plus the entire principal paid to buy the annuity stays with the issuing company. Of course, you could choose income options that would continue to generate payments for a fixed period of time or until a survivor dies, but those options provide smaller monthly checks. One final downside: the monthly payment from an annuity doesn't automatically adjust with inflation unless a costly inflation rider is purchased.
Enter managed-payout funds
With all the downsides to an annuity, it was only a matter of time before an alternative emerged. That happened in 2007 with the launch of the first managed-payout mutual funds.
In contrast to an immediate annuity, most managed-payout funds have no up-front fees (as long as they're no-load), just the typical expense ratio found with all mutual funds. While the initial minimum investment for such funds is fairly high — typically $25,000 — you maintain control over the principal, and have the freedom to cash out or move the money to another investment at any time. Upon your death, your designated beneficiary receives any remaining balance.
Managed-payout funds typically follow one of two approaches. Some, such as those offered by Fidelity and PIMCO, pay out earnings along with a portion of principal, with the goal of completely distributing the account balance by a specific date. Whereas target-date funds are designed to help you build a nest egg by a certain date, these managed-payout funds are designed to help you spend your nest egg by a certain date — hence, their morbid nickname, "death-date funds."
Fidelity offers 14 "Income-Replacement" funds, with end dates ranging from 2016 to 2042 (in two-year increments). At present, a $25,000 investment in the Fidelity Income-Replacement 2034 fund would pay $116 per month. As with all of the company's Income-Replacement funds, it would "seek" (but not guarantee) to provide payment amounts that increase each year with inflation, with the balance depleted by its end date.
Fidelity's investment strategy involves investing in 15 underlying Fidelity stock and bond funds. The mix between stock and bond holdings is rebalanced each year, moving toward a higher percentage of bond holdings as the end date draws near.
The other managed-payout approach, followed by Vanguard and Schwab, operates like an endowment, aiming to pay out only dividends and earnings.
Vanguard introduced three managed-payout funds in 2008, but recently announced that it will merge them into one fund, the Vanguard Managed Payout Fund, beginning in January 2014. The fund will have an "annual distribution target rate of 4%," the "target" language reflecting the lack of a guarantee. While the fund is designed to retain its principal, the prospectus makes clear that in some years its payout could include some "return of capital" and also that the fund's monthly distributions "could go up or down substantially from one year to the next and over time."
Performance and conclusion
Managed-payout funds may be worthy of consideration for older investors seeking more peace of mind and less hands-on involvement in managing their investments. However, investors looking for a guaranteed income stream from a nest egg need to keep in mind that managed-payout funds don't offer that. The amount of income distributed each month is typically recalculated once a year and may increase or decrease based on the fund's past performance.
Because each fund company has designed its managed-payout products differently, it's crucial to understand the details of how the fund you are considering works. These funds vary widely in asset allocation (and therefore, risk), as well as how payout amounts are determined. In many cases, those considering using a managed-payout fund should do so with only a portion of their nest egg.
While these products are still new and relatively untested, their performance thus far has been decent. Direct comparisons are difficult because each fund has its own asset allocation that changes over time. But generally speaking, over the past five years Vanguard and Schwab's managed-payout funds have provided returns roughly 2% per year below that of an Upgrading portfolio with a similar stock/bond allocation, while Fidelity's have run roughly 1% below. Those aren't terrible returns, given that these funds also provide the monthly payout feature. Unlike most traditional annuities, at least these managed-payout funds are providing reasonable returns to investors.
Not surprisingly, though, we think the best route for most investors is to continue managing their own Upgrading and/or Dynamic Asset Allocation portfolios during retirement. Doing so seems more likely to achieve better overall performance, and more precisely meet each individual's income needs. If managing your own Upgrading/DAA portfolio becomes too difficult at some point, automated approaches to these strategies are available.