A few weeks ago my 58-year old brother sent me an article on a new kind of investment that he described as "a mutual fund that invests your money for you and sends an income check every month for as many years as you choose." Bill is a retired postal worker with a strong knack for saving but little interest in investing, so I figured that if these funds struck a chord with him they stand a good chance of resonating among the millions of other baby boomers who now control over $13 trillion in investable assets.
The latest, most evolved version of retirement income funds from Fidelity and Vanguard that my brother was referring to mark the mutual fund industry's most ambitious effort yet to remove much of the decision-making associated with retirement investment and distribution planning. They speak to the fear of running out of money that inhabits the thoughts of many retirees by managing regular retirement income payouts under the umbrella of an all-in-one, professionally-run diversified investment.
The 11 Fidelity income replacement funds, launched in October, have targeted maturity dates ranging from 2016 to 2036. The funds with longer maturity dates invest more aggressively than those with a shorter time frame, and all of them migrate to a more conservative stance as their time lines shorten. An optional feature allows investors to receive regular monthly payments consisting of return of principal and earnings until a specified date, when the account is emptied.
Vanguard's version of one-stop retirement shopping, three Vanguard Managed Payout Funds, will also have a check-a-month feature when the firm rolls them out, which is expected early this year. The funds, all of which invest in Vanguard funds and may include a market neutral component, anticipate an annual distribution rate of 3%, 5% or 7%. Unlike the Fidelity funds, the Vanguard offerings are designed to distribute income without dipping into principal. Both the Vanguard and Fidelity versions adjust payments each year based on investment returns in the accounts and other considerations, and provide no income guarantees. Annual expenses are 34 basis points for the Vanguard funds, and 54 to 65 basis points for the Fidelity offerings.
Some observers believe structured retirement payout funds such as these represent a new generation of products that stand in direct competition to annuities. "I think we are definitely going to see a lot more of these kinds of retirement income solutions coming down the pike," says Francois Gadenne, chairman of the Retirement Income Industry Association (RIIA). Fidelity Insight editor Eric Kobren calls the funds a good choice for people "who want to keep things as simple as possible during their retirement years."
The marketing muscle behind the earliest ones out of the gate paves the way for other financial services companies to follow in their footsteps, and some have reservations about the addition of another competitor in the lucrative rollover market. "The greatest advantage of these funds is their low cost," observes William Bengen, a financial advisor in El Cajon, Calif. and author of Conserving Client Portfolios During Retirement. "They are going to be tough competition for advisors charging considerably more."
But the funds face stiff competition as well. Many investment professionals view building customized retirement portfolios designed to generate solid returns, provide income, keep pace with inflation, and leave behind an estate-an essential part of their service that is impossible to replicate in a packaged solution. And there are other, less sophisticated but entrenched, approaches to income replacement that people may find hard to give up. Mutual funds have long allowed investors who want steady monthly income to arrange for monthly fixed checks consisting of income, principal, or both, and living off of dividend checks or interest from a laddered portfolio of bonds is nothing new.
Still, about 100 financial advisors attended each of the eight Fidelity road shows conducted late last year by Dan Beckman, vice-president of product management at Fidelity. He says they are asking a lot of questions and seem curious, but admits they aren't jumping in with both feet. "We're anticipating a slow build as people begin to understand how these funds work and review their books to see which clients they make sense for," he says, adding that the funds are "a way to implement a partial solution to a retirement income plan that is replicable across a large number of accounts." Some attendees express concerns about the tax reporting implications of receiving 12 separate distributions consisting of both principal and earnings, which Beckman says is handled in the same manner as any other systematic withdrawal plan.
Others have reservations similar to those of Dan Roe, principal with Budros, Ruhlin & Roe, who views the lack of customization as a drawback that makes them inappropriate for most of his clients. "We can be responsive to market conditions, recognize opportunities for tax savings, and customize strategies for each individual," he says. "That's something these funds can't do." At the same time, he believes they might fit the bill for "smaller client accounts, or perhaps for parents of clients. They're one of the more interesting products we've seen in a very long time, although we haven't really taken a close look at them yet."
Beckman acknowledges that "for very large clients a packaged product may not be the best choice." At the same time, he says, they are flexible enough to be able to adapt to specific situations for many people. Investors can turn the payment spigot on or off an unlimited number of times, at any time, without charges or penalties. If a client received a sudden influx of cash such as an inheritance, he might decide to stop payments and re-invest earnings in the fund, or switch into a fund with a longer time horizon and lower monthly distributions. Funds with a ten-year time frame could be useful for clients who want an income bridge between early retirement and social security. Someone could use a 25- or 30-year fund to receive lower payments and possibly leave more money for heirs.
Ellen Rinaldi, a principal at the Vanguard's investment counseling and research division, comments that her firm's funds "are a viable choice for people who have the majority of assets in a 401(k) plan, and who want to roll it into an IRA and take distributions to support their lifestyles. They may also want to leave assets for heirs or have them available for health care expenses or emergencies."
Although the funds are careful to make no promises or guarantees regarding the level of retirement income and how long it can be sustained, the structured nature of their distributions and the message that those payments are structured to last through retirement make comparisons to annuities inevitable. "These are not annuity substitutes, although some people who don't like annuities are looking at these funds as an alternative to them," says Beckman. "But they can be used with annuities as part of an overall retirement plan."
Critics counter with salvos aimed at the predictability of the funds' income payments. "These products fall short in terms of providing what a retiree needs, and that is to have a segment of income that addresses longevity risk and is truly guaranteed," says David Macchia of Wealth 2k, a financial services marketing consulting firm whose client list includes a number of insurance companies. "You don't take accumulation logic and try to apply it to the distribution phase. A targeted rate of return decades into the future is far from the guarantee of an annuity."
Jerry Golden, president of MassMutual's Income Management Strategies Division, believes the funds "are geared primarily for do-it-yourselfers. They may be part of a broader solution, but not a major part of it." He also questions whether they coordinate with a total investment plan as neatly as an immediate income annuity does. "If you have one part of a portfolio with a guaranteed level of retirement income you can be more aggressive with other assets. The problem is that these funds invest less aggressively over time," he says.
Bengen is concerned that people may not be prepared for a significant drop in monthly payments if there is a steep market decline or a prolonged bear market. He also questions the expectation of one of the Vanguard funds to sustain a 7% annual distribution rate without dipping into principal. "I think a withdrawal rate of 4.5% to 5% is a lot more realistic," he says. "My understanding is that the range of withdrawal rates is based on back testing, and I haven't seen any of the supporting data yet." He says the situation reminds him of closed-end funds with a managed distribution policy that ended up dipping into investment capital to sustain the level of monthly income payments investors had come to expect.
Perhaps a larger issue is whether clients need managed payout funds or annuities at all. High-net-worth individuals may do just fine with a well-diversified portfolio rather than products designed to generate a specified level of retirement income, says RIIA's Francois Gadenne. "An often-cited rule of thumb is that if someone has at least 30 times their annual income requirement in investable assets they are considered as a high-net-worth client. It's not just about how much someone has. It's also about how much someone spends."