In a famous scene in the movie Moonstruck, a plumber named Cosmo explains to a young couple why he only uses copper pipe. Aluminum is garbage, he says. And bronze is pretty good as long as nothing goes wrong. But something always goes wrong.
You might have said the same thing about managed payout funds in 2008. A fledgling mutual fund concept barely out of the nest, many of these funds got slaughtered when they tried to fly at the wrong time-right before the sky fell and the market crashed.
Designed to turn nest eggs into income streams, managed payout funds send out regular checks to investors, often once a month, based on some number like three-year average NAV, ten-year yield or a target liquidation date. But the stock market slide in 2008 forced funds offered by Vanguard, Fidelity and others to eat into principal to make the payouts, which effectively handed investors' money back to them. Even now, after the market has bounced back, some of these funds are still paying back principal because of the way they are calculated.
"In the first year of existence, virtually all of their distributions were composed of return of capital, so they essentially gave shareholders their money back," says Dan Culloton, an associate director of fund analysis at Morningstar in Chicago who follows Vanguard's managed payout products. "That improved somewhat in 2009 as the markets improved and the performance of the funds improved. But since their trailing returns since inception were still negative, a large portion of the [Vanguard] funds' distributions last year were still return of capital, and even this year a large portion of their distributions are return of capital."
"I don't know if you call it bad luck, but it's the reality of the investment market," concedes John Ameriks, who leads the investment counseling and research team at Vanguard, which launched its three managed payout funds in 2008. "If it wasn't bad luck, it was certainly bad timing. But Vanguard said for years-don't try to time the market. We've looked back at history, and there are only a few months where the subsequent performance would have been worse than what we saw when we launched these funds."
No matter what the result of 2008, the managed payout concept is a compelling one for mutual fund companies. With baby boomers rushing toward retirement, investors like never before want to start drawing down money, and fund companies rightly fear the kitty they've told people to build up for years will now leave them and go to the banks or to insurance companies and their annuities. That has led some to wonder whether this is a concept driven by marketing more than sound investing.
The mutual fund companies' pitch is that these funds offer the payout at a much lower fee, at 50 to 90 basis points depending on the fund strategy, while annuities squeeze investors for 2%-3% fees. Despite the rough start, fund companies are still coming up with new versions of the managed payout idea. PIMCO just released one at the end of 2009 that invests mostly in TIPS. Charles Schwab, John Hancock, ING and Russell also have their own versions.
But those lower fees come at a price. Managed payout funds do not offer the same guarantees. So the threat mutual fund companies face from the insurance product is obvious.
"The whole idea is they're trying to come up with a product that would compete with an annuity contract," says Raymond Benton, a financial advisor with Lincoln Financial Advisors in Denver. "So you'd have not necessarily a guarantee, [but] they're trying to at least give you some assurance that you can take an income stream from this fund and then it's going to last you for the rest of the specified term."
Vanguard has three portfolios that offer 3%, 5% and 7% payouts depending on whether the focus is more on growth or distribution (these payouts are supposed to be based on their respective portfolios' average daily share price over the past three years-but the basis is currently starting from inception, since the funds have no three-year track records as of yet). The monthly distribution per share is equal to the annual distribution rate (3%, 5% or 7% divided by 12) and then that is taken times the average daily account balance of a hypothetical account over the last three years.