Spending Down Your Portfolio

Last Updated Feb 21, 2011 10:10 AM EST

Do you want a monthly stream of cash but aren't ready to jump into an annuity? Two relatively new concepts that might fit the bill are the Vanguard Managed Payout Funds and the Fidelity Income Replacement Funds. Both are fund of funds that aim to provide a monthly cash flow, though payment streams can change over time with either of these funds.

Both were launched just before the market crash. Now that the stock market is near an all-time high, it's worth giving these a good look. Here's how they work.

Fidelity Income Replacement Funds
Fidelity's funds work to gradually liquidate your portfolio so that the fund is completely depleted in the given year. An investor in search of a 30 year cash flow could buy the Fidelity Income Replacement fund 2042 (FIXRX). Fidelity's calculator estimates a $100,000 investment would pay $412 per month, or $4,944 annually, and is designed to keep up with inflation. The fund has a 0.68 percent annual expense ratio and is roughly 65% in equities.

Vanguard Managed Payout Funds
The Vanguard Funds work as an endowment intended to last into perpetuity. The three funds make monthly distributions and have targeted annual payouts of three, five, and seven percent. The lower payout fund is intended to grow in real terms, while the five percent payout is intended to keep up with inflation.

The Vanguard Managed Payout Growth and Distribution fund (VPGDX) targets a five percent annual distribution, paid monthly. It has a 0.48 percent annual expense ratio, and is roughly 70 percent in riskier equity-like assets. Vanguard's calculator estimates a $100,000 investment would pay $367 monthly, or $4,404 on an annual basis. The yield of 4.40 percent is lower than the five percent target because the payout formula uses a three year rolling average which, of course, includes the lower stock prices in 2008 and 2009.

More on the Vanguard Funds
I spoke with John Ameriks, one of the Vanguard principals responsible for launching these funds. He noted that these funds were designed for those less comfortable using annuity products for monthly cash flow. The fund lowers the specific risk of a single insurance company not being around, but does not have a guaranteed payment, as annuities typically do.

Ameriks stated, "The funds are meant to supplement Social Security and defined benefit payments for the consumer." They also provide more protection against inflation than an immediate annuity purchased without an inflation rider. He stresses that they are not annuity substitutes because of the lack of guarantees.

This VPGDX fund is comprised of the following underlying holdings:

The "other" is a commodities strategy. Though I generally like the funds, I have a particular concern with the Market Neutral Fund (VMNFX), which is a long/short fund that attempts to deliver more than the risk free rate. According to Morningstar, this two star fund has lost an average of 5.72 percent annually for the last three years. Ameriks noted the fund had prior strong performance, and Vanguard is committed to keeping it. Because this fund is designed to return a fixed income type of return, the 70 percent equity-like assets noted above excluded this fund.

A brief history of the fund
This fund was launched on May 2, 2008, just before the stock market plunge. The chart below illustrates how an ill-timed $100,000 investment lost more than 40 percent of its value, yet has since recovered to being down only 13 percent, after making monthly payouts. Because the payouts are based on a rolling average, the monthly payment only declined by 24 percent from $416.50 to $317.00. The payment inched up to $323.50 in 2011, as markets recovered.

My take on these funds
Both the Fidelity and Vanguard funds are intriguing alternatives to immediate annuities and offer monthly cash flows in retirement. I like the concept of the Fidelity Income replacement funds offering a glide path to spending down principal. Naturally, one needs to keep funds in reserve for this fund as a contingency for outliving the date the fund is fully depleted.

The Vanguard funds offer lower costs and some of my favorite diversified total index funds. I've always been troubled by the market neutral fund and commodity strategies, however. The market neutral fund has certainly not lived up to its purpose. I'd prefer to see the three fund simplicity and lower costs Vanguard uses in its Target Retirement Funds.

In my opinion, both the Fidelity and Vanguard payout funds have performed relatively well during the greatest stock market plunge since the great depression. Both are viable options for creating a cash flow stream in retirement. Neither, however, are options for your entire portfolio. I'll be watching both carefully.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.