Plenty of retirees know what they want: investments that provide guaranteed lifetime income and the flexibility to withdraw principal every day. That's a tall order, and traditional investments such as annuities and mutual funds have not offered perfect solutions. To improve the traditional vehicles, fund companies have been introducing a wave of innovative products. All the new approaches have flaws. But they represent steps toward achieving the ideal solutions that retirees crave. By incorporating one or two of the innovative vehicles into balanced portfolios, advisors may be able to provide more security for clients.
Among the most important developments are managed payout mutual funds, which aim to provide retirees with steady monthly paychecks. Companies with offerings include Fidelity, Charles Schwab, and Vanguard. The funds seek to pay targeted annual distributions that can range from 3 percent to 7 percent of total assets. Portfolio managers emphasize that the payout vehicles are not annuities, and they do not come with guarantees. Because returns depend on the performance of investments, monthly payouts can vary. The payout funds follow different strategies. Some aim to provide income for fixed periods, such as 10 years, while others plan to function for indefinite periods.
The biggest player is Vanguard with $810 million in assets in three funds. Each January Vanguard sets the monthly payout that will remain fixed for the rest of the year. Say an investor wants to receive $1,000 a month. Using a Vanguard online calculator, he can figure exactly how much must be invested to reach the target. The payouts are based on the average net assets during the past three years.
The Vanguard payout funds are designed along the lines of endowments. The aim is to produce growth and income, so that shareholders can spend a steady figure — such as 5 percent of assets annually — without tapping the principal. To accomplish the goal, the Vanguard funds follow a fairly aggressive approach, investing heavily in stocks. Vanguard Managed Payout Growth Focus (Ticker: VPGFX), the company's riskiest payout choice, keeps 80 percent of assets in stocks, with most of the money invested in Vanguard index funds, such as Vanguard Total Stock Market (VITSX).
Vanguard's payout strategy is very different from the approach used by the target-date retirement funds that are run by Vanguard and other companies. The typical target-date funds start with stock-heavy allocations and gradually shift to putting most assets in fixed-income as the saver ages. For its payout funds, Vanguard starts with lots of stocks and keeps the allocation about constant over the years. Vanguard principal John Ameriks says that target-date funds are run conservatively so that retirees won't face big losses.
So far, the Vanguard payout funds have produced solid returns. During the past three years, Vanguard Managed Payout Growth Focus returned 13.9 percent annually, outdoing 95 percent of retirement income funds. But the Vanguard approach comes with risk. In the downturn of 2008, the Vanguard managed-payout funds got slammed. Since then the funds have been forced to liquidate assets and pay out principal in order to maintain distributions. To appreciate the problem, consider that Vanguard Managed Payout Growth Focus aims to distribute 3 percent of assets annually. In 2011, investment income covered only 42 percent of the distribution. In order to maintain the distribution, the fund had to return capital.
While Vanguard has been forced to dip into principal, the Schwab payout funds have avoided capital returns by following a conservative strategy. The most aggressive Schwab offering is Schwab Monthly Income Moderate Payout (SWJRX), which keeps 40 percent of assets in equities and the rest in fixed income. The fund aims to pay 3 percent to 4 percent of assets annually. Each month, the Schwab portfolio managers estimate how much income they can distribute without resorting to returns of capital. Because of the heavy bond holdings, the payouts have remained fairly steady since the fund began operating in 2008. During market downturns, the big bond holdings enabled the Schwab funds to outdo their Vanguard competitors. But Vanguard raced into the lead during market revivals in 2009 and 2010.
Like conventional mutual funds, closed-end funds have been working to develop managed payout strategies. According to the Closed-End Fund Association, 36 funds now offer managed distribution programs. Funds typically announce that they will deliver minimum annual distributions, such as 5 percent of assets. If the funds cannot cover the distributions with capital gains and investment income, then portfolio managers must return capital. Among funds with big distribution policies is Gabelli Equity (GAB), which seeks to pay out at least 10 percent of its assets annually. Other funds that have distributed more than 5 percent include Cohen & Steers Dividend Majors (DVM), H&Q Healthcare Investors (HQH), and John Hancock Bank & Thrift (BTO).
Funds with managed distributions can be attractive choices for retirees, says John Cole Scott, executive vice president of Closed-End Fund Advisors, an RIA in Richmond, Va. But Scott says investors must be wary of funds that can only cover their distributions by returning substantial amounts of capital. Big returns of capital can erode a fund's long-term total returns. “If you see a fund that is distributing twice what competitors are, then you have to be wary,” he says.
Scott says some funds are now returning capital in order to maintain double-digit distributions. Among the big payers is Cornerstone Strategic Value (CLM), which distributed 25 percent of assets, including mostly returns of capital. Scott warns that the distribution cannot be maintained indefinitely.
Seeking to raise its share price, Adams Express (ADX), a closed-end fund with $1 billion in assets, recently announced that it would offer a 6 percent annual distribution. One of the oldest funds, Adams was founded in 1929 and has long focused on buying blue chips. The goal has be2en to operate a portfolio that would outdo the S&P 500 while taking slightly less risk. During the past 10 years, the fund has achieved its target. In a decade when blue chips have often been out of favor, the discount has climbed from 10 percent to 16 percent.
Now the Adams Express managers hope that the managed distribution will lower the discount. John Cole Scott likes the strategy. He recommends the fund and says that the discount could drop to 14 percent as shareholders begin receiving increased distributions.
Bond giant PIMCO is cooperating with insurer MetLife to offer a strategy that combines a mutual fund and an annuity. Under the approach, a retiree would start by buying one of the PIMCO Real Income funds. These come with maturity dates such as 2019 or 2029. The funds provide monthly income until the maturity. At that point, an annuity from MetLife would begin providing lifetime income.
The PIMCO Real Income funds are extremely reliable because they invest in a portfolio of Treasury Inflation-Protected Securities (TIPS). Some of the bonds mature each year, and investors receive the principal along with interest. By the maturity date, the investor receives the initial principal and the fund closes. Plus, the value of the fund rises with inflation.
Say you put $100,000 into PIMCO Real Income 2019 (PCIAX) at the beginning of 2010. During the first year, you would have received one tenth of your principal back plus interest and inflation adjustments for a total of about $12,000. You could have done about that well with a bank CD. But the PIMCO investors can withdraw at any time with no penalties. Savers who cash CDs early must pay penalties. More importantly, PIMCO shares provide inflation protection. After a PIMCO payout fund matures, investors can purchase longevity insurance from MetLife.