Now that the Baby Boomer generation is retiring in droves, fund companies are focusing on a thorny question: How can retirees obtain reliable income from their investments? Since September, half a dozen companies — including Russell, DWS Scudder and Charles Schwab — have introduced funds that seek to pay out regular checks. The new funds take varying approaches. Some aim to provide income for a fixed time, such as 10 years, while others seek to generate income for indefinite periods. “There is a lot of trial and error going on right now as people try to figure out what will succeed in the market,” says Luis Fleites, director of retirement markets for Financial Research Corporation. “We will probably see different products introduced as it becomes clearer what strategies work.”
In some respects, the new payout vehicles resemble target-date funds. Both kinds of funds are diversified portfolios of stocks and bonds. But the target-date funds are designed to accumulate assets so that an investor is ready to retire on a particular date, such as 2020. To achieve the goal, an investor makes regular deposits, and the fund gradually shifts from a stock-oriented allocation to a heavy emphasis on bonds. In contrast, the payout funds are actively managed to provide current income. While most payout funds gradually move to focusing on bonds, the strategy can change. If stocks suddenly collapse, some funds can shift abruptly to bonds, making sure that monthly income checks will continue.
Each fund has a different payout scheme. Vanguard Managed Payout Distribution aims to provide about 7 percent of net assets annually. Fidelity Income Replacement 2016 was designed to pay about 12 percent the first year. After that, the annual payments should increase with inflation.
Advisors who are considering whether to use a retirement fund should pay close attention to the client's expected withdrawal rate, says Garry Shea, a partner with D.A. Davidson & Co., a brokerage in Spokane, Washington. Clients who plan to withdraw only 3 percent of assets annually could use a portfolio of conventional mutual funds — and run little risk of exhausting their assets. But if a client needs to withdraw more than 5 percent, it may be useful to rely on a payout fund that is dedicated to maintaining income during downturns. “If you take 6 percent payouts during a severe downturn, a portfolio of typical mutual funds can be decimated, and a retiree might never recover,” says Shea. “It takes a delicate touch to maintain retirement income during hard times.”
Fund companies emphasize that the payout funds are very different from annuities. While annuities can provide guaranteed income for life, most payout funds do not come with guarantees. The exact amount of the returns from payout funds depends on the market performance of portfolio investments.
Make no mistake, the safety of annuities comes with a price. Many variable annuities charge annual fees of more than 1.5 percent. In contrast, Fidelity payout funds have annual expense ratios of 0.67 percent or less. In addition, annuities can be inflexible. Once an investor starts taking income, he cannot necessarily withdraw any principal. Most payout funds allow investors to make deposits and withdrawals every day. If an investor suddenly faces an emergency, he can cash out of his payout fund entirely. “To get safety and flexibility, it may make sense to hold a mix of guaranteed annuities and other investments that are not guaranteed,” says Dan Beckman, vice president of product management for Fidelity Investments Institutional Services.
Beckman says that an investor might decide to rely on payout funds for income during the first several years of retirement. The retiree could then turn later to annuities. That might maximize total returns, since some annuities pay higher annual income to people with shorter life expectancies.
An investor could hold a payout fund for several years, liquidate it and use the proceeds to buy an annuity. Russell LifePoints 2017 fund aims to pay out 7 percent of assets for 10 years. When the fund matures, the investor could buy a new payout fund with a 10-year maturity — or invest in an annuity. “The payout fund lets people defer buying an annuity for long periods of time — perhaps forever,” says Tim Noonan, managing director of Russell.
To satisfy a variety of clients, Russell is permitting advisors to tailor payouts. A client can elect to take monthly or quarterly payments. If a client does not need income for several months, the cash can be reinvested in the fund. One payout fund with elements of an annuity is DWS Lifecompass Income. The fund aims to pay 8.25 percent of assets annually for 10 years. At the end of that time, the goal is to return all the principal to investors. If investment returns are strong, investors could get more than their principal back. But if markets sag, the fund pledges to return at least 17.5 percent of principal.
Because the payout funds are all new, it is difficult to gauge how they will perform under different market conditions. However, most portfolios seem to be invested conservatively. DWS Lifecompass Income, which matures in 2017, recently had 77 percent of assets invested in fixed income. Fidelity Income Replacement 2016 had 64 percent in fixed income. Fidelity's funds with longer maturities keep more aggressive portfolios. Fidelity 2026 holds 48.3 percent in fixed income.
Most of the payout funds invest in a portfolio of mutual funds. Fidelity's payout funds hold many of the same funds that are used by the company's Fidelity Freedom target-date funds. But the Fidelity payout funds tend to be more conservatively managed. The payout funds have relatively big stakes in Fidelity 100, an index fund of large-cap stocks, while Fidelity Freedom funds have bigger holdings of actively managed funds. “For the income replacement funds, we are trying to take some of the risk off the table,” says Dan Beckman of Fidelity.
While some of the payout funds are being sold directly to retail investors, many companies are concentrating on reaching advisors. The goal is to provide simple packages that will enable advisors to manage income and ensure that clients can have secure retirements.
Funds designed to generate retirement income, some paying more than 5 percent of assets.
|Fund Name||Ticker||Inception||Expense Ratio|
|DWS LifeCompass Income||INCAX||12/19/07||1.87%|
|Fidelity Income Replacement 2016||FIRJX||8/30/07||0.54|
|Fidelity Income Replacement 2026||FIROX||8/30/07||0.60|
|Russell LifePoint Retirement Distribution||RRDAX||12/31/07||1.34|
|Vanguard Managed Payout Distribution||VPDFX||4/21/08||0.57|
|Source: The Companies|