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Retirement Income: Managed Payout Funds

It's a message as ubiquitous as stop smoking, wear your seatbelt, and exercise: You need to save more for retirement. But after decades of selling us the investments to facilitate that saving, financial firms are now touting products aimed at helping you withdraw your savings once you retire.

Some of the biggest financial firms, including Vanguard, Fidelity, Charles Schwab and Pimco, have launched “managed payout” funds (also called income replacement funds) in an effort to provide customers with an easy way of managing their retirement income — and, of course, to keep or attract the generally lucrative baby boomer customers.

The idea is simple, and the appeal evident: Simply put your savings into one of these funds, choose the amount of income you’d like to receive and you’ll immediately begin receiving regular checks throughout retirement. In practice, though, the decision is a bit more complicated.

How the Funds Work

Most managed payout funds aim to preserve your principal — meaning that the payouts are dependent on the fund’s ability to generate high enough returns to pay out your desired payout. Vanguard, for instance, offers 3 percent, 5 percent and 7 percent payout funds. For you to receive 7 percent of your principal annually without dipping into your principal, the fund manager needs to generate at least a 7 percent return — which means taking a fair amount of risk. Funds from Charles Schwab, John Hancock and DWS Scudder take a similar approach.

Fidelity’s income replacement funds take a different tack: They are designed to liquidate entirely by your chosen end date (prompting some snarkier analysts to call them “target death funds”). Like target-date funds — which invest in underlying stock and bond funds and become more conservative as your retirement date nears — these are funds-of-funds with changing allocations. Because they pay out principal as well as earnings, they’re generally invested more conservatively than managed payout funds.

The Catch: No Guarantees

Don’t confuse these funds with a more common retirement income product: annuities. An annuity guarantees you a specific payment at specified times, so long as the issuer stays in business. Managed payout funds, income replacement funds, whatever name they go by, make no such guarantees, and many planners fear investors will not realize that. “I’d put all these funds under the heading of ‘false sense of security,’” says New York financial planner Gary Schatsky, who objects more to the marketing of the funds than their structure. “There’s nothing inherently wrong with them, but they come with an implicit guarantee. If you use these arrangements, know that your investments are not on autopilot.”

With a managed payout fund, you’re subject to the vagaries of the markets. In the two years since many of these funds launched, the evidence of how badly they can disappoint is clear. Vanguard’s Managed Payout fund with a distribution focus lost 25 percent in 2008, the year it opened. Even though it was up 22 percent in 2009, the early losses forced the firm to return investors’ principal to meet the payout goals. You don’t pay taxes on that so-called return of capital, but that’s about the only good news. “It diminishes what you have in the fund, and you lose the benefit of compounding that helps to create a lifelong stream of income,” says Morningstar analyst Dan Culleton.

An annuity’s guaranteed income, however, comes with a catch. In most cases, you can’t get your money out. With a managed payout fund, you can withdraw (or contribute) any amount at any time, and any balance that’s left when you die goes to your heirs.

The Role in Your Portfolio

In effect, says Stewart Welch, a financial planner in Birmingham, Ala., you’re trading one form of risk for another. “With annuities, you’re accepting some form of credit risk — that the insurer won’t be able to pay,” Welch says. “With managed payout funds, you’re accepting market risk.”

So how can a managed payout fund fit into your retirement income strategy? Welch suggests using them to diversify. Buy an annuity to cover your fixed costs and use a managed payout fund for spending that can be cut back if the fund underperforms.

“These are not a substitute for a guaranteed product,” agrees John Ameriks, head of investment counseling and research for Vanguard, who recently partnered with Wharton’s Pension Research Council to study retirement income strategies. “There’s a big debate as to the right approach to retirement income, and our main conclusion is that there’s no single metric to rank ‘the best.’”

How to Pick a Fund

Expect to see more managed payout funds soon, each with its own spin. Given the category’s tiny size — the funds hold just $835 million, less than the assets of a single typical fund — and relative newness, it’s hard to say what will become the standard. Negotiating the differences between the funds can be tricky, so ask yourself these questions before you invest.

Do you want to have money left over? Endowment-style funds, like Vanguard’s, are designed to preserve your investment, with payments covered by portfolio gains and income. Time-horizon funds, like Fidelity’s, pay you back your original investment as well as any gains by the end date you pick. Neither option is necessarily better, though time-horizon funds may provide a higher income since the payouts eventually include principal. But once they liquidate, your income is gone.

How much income do you need? Vanguard’s funds are designed to pay 3, 5 or 7 percent of the funds’ average net asset value over rolling three-year periods. So the dollar amount fluctuates. The payouts for Fidelity’s Income Replacement funds are specified in advance, though reviewed periodically.

How much risk can you take? Each firm tends to have a uniform investment strategy, while offering variations that appeal to more or less conservative investors. Vanguard funds, which aim to preserve your investment, are relatively aggressive — they have to be in order to generate those payouts — investing largely in stocks and commodities; Pimco’s funds invest solely in Treasury Inflation-Protected Securities, or TIPS.

What are you paying? Managed payout funds are funds of funds: So in addition to whatever fee the fund is charging, you’ll also be dinged for each of the underlying funds’ fees. With the vast majority of assets held by Vanguard and Fidelity, two low-cost fund groups, fees aren’t especially high. But if you don’t want to pay anything for a strategy you could do yourself, planner Welch suggests simply seeing how the fund is allocated by checking the firm’s Web site or Morningstar.com, buying the underlying funds — and managing your own withdrawals.

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