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.

In 2009, the payouts on the 3% growth fund dropped by about 17% to 18%, according to Vanguard. And the 2010 payments will fall again by almost 10%, even though the underlying assets are growing. The 3% growth focused fund, for example, estimates a $240 monthly payout for an investment of $100,000 in 2010, while its 5% growth and distribution fund pays $407 a month and its 7% distribution focused fund pays out $583.

And much of the payouts have continued to eat into principal. In 2008, 100% of the funds' payout was coming straight back from investor capital. In 2009, those amounts fell, but not entirely: The distribution focused fund continued to return nearly 40% of principal to investors while the growth and distribution fund returned a bit over 21%. Only the 3% growth fund returned no capital in 2009.

"If you invested in March of 2009," says Culloton, "you would have thought, 'Excellent! I got in at the bottom and the market has done nothing but go up since then. My personal payment should increase when they recalculate this thing in January of 2010.' Well that didn't happen. People who invested in March 2009, they all declined because the formulas that calculate the payments are based upon trailing multiyear performance, so they're not based upon Dan Culloton's net asset value since March 2009, they're based on the funds' historical net asset value."

Charles Schwab's Monthly Income Funds have a similar method as Vanguard's, offering 3% to 6% payouts in its funds based on historic yield environments over a ten-year period.

Fidelity's strategy, meanwhile, is different, as it uses funds with different target dates, investing more aggressively for longer dated funds using a glide path similar to that of a target date fund and gradually ramping up the payouts each year under its optional Smart Payment Program until the fund is totally exhausted.

The Fidelity Income Replacement Funds invest with a target date up to 35 years out, gradually ramping up the payouts until the fund is used up. The payouts are reset annually based on last year's NAV. The annual target payouts rise so that they might be 5% of NAV at the beginning, divided by 12 monthly payments, and then rise to, say, 6.5% or so 20 years out, divided by 12 payments. For the last year, finally, the fund will pay out 100% of what's left over divided by 12. The funds reset at the end of each year according to what the market has done, and naturally, they paid out less in 2009 after the carnage in 2008.

Dan Beckman, a vice president of investment product management and development at Fidelity, says that clients don't mind eating into principal because the whole idea is for the fund to exhaust itself.

Fidelity says that in '08 and '09, payments were made up of about 35% from dividends and about 65% from the automatic selling of shares. The company says that its funds, unlike some others, return principal through the automatic selling of shares, which is clearly seen by the shareholder whereas the return of capital through a distribution may not be as evident.

"I think maybe what's different from our product design from some of the other funds that may have come out shortly after ours is that our product by design is meant to return the investors' investment to them over that defined time horizon," says Beckman, "so ours is working exactly as intended on that dimension. But the proposition is, you put your money in, we manage it from an asset allocation perspective, as well as a withdrawal perspective, to make sure that these payments last over that time horizon."

The mutual funds calculate these income streams to dampen volatility so that the investor can rest easy and not suffer the slings and arrows of a volatile market.

"A mutual fund doesn't really have this formula to calculate the payments to smooth out the payments over time," says Culloton.  He says that if an investor simply tried to take out the money on his own at regular intervals, he'd have to settle for something like bonds, which aren't paying out very much, or aggressive equity holdings whose returns are too tumultuous for a sustainable withdrawal rate.

"It will be very lumpy," says Culloton. "There will be years where you're not getting the type of capital gains and income and the overall appreciation to support those payments."

Still, Culloton, among others, says that managed payout funds are still an unproven product. He compares them to mini-endowments. The Vanguard funds in particular, he says, have been moving into riskier territory like REITs, futures and commodities to get returns. And Culloton says there has even been talk of an absolute return type hedge fund product run by the company though it hasn't been implemented yet.

"One thing that worries me is that endowment-style investing is all the rage because the trailing returns of the last 10, 15, 20 years of Yale and Harvard have been phenomenal and they've gotten a lot of press and everyone thinks they're geniuses. That makes me a little bit nervous; it looks a little bit like investing in the rear-view mirror."

Because these funds aren't guaranteed, Beckman and Ameriks both say that they shouldn't be used like annuities but instead should be used for more discretionary spending needs-and stress that because they are not guaranteed, they are not for essential expenses. Indeed, they suggest that the funds' lower payouts during the market downturn were in some ways helpful for investors, forcing them to cut back on exactly the kind of discretionary spending these products would be used for.

"What these funds did is they provided a useful signal," says Beckman. "This is how much you should feel confident in spending and this is how much you ought to pull back to get that annual reset. So the funds did go down. And when we saw the year-end balances at the end of '08, we reset the payments and the payment amounts went down. The good news is that bad markets are often followed by good markets.

"Obviously it's not a comprehensive solution," he continues. "It is an element of an overall portfolio that we think has different characteristics and therefore provides a diversified income stream to a retiree."

Still, some financial advisors say that the way the funds are being marketed, they will indeed confuse investors who might see them as cheap annuity substitutes.

"If these products are going to be used, I think they have to be used in the proper context of a person's individual retirement income strategy," says Dean Barber, the founder of Barber Financial Group in Lenexa, Kan., "and I don't think that they should be a stand-alone program. I'm not saying that they don't have a place at all. But I would be skeptical of thinking that people can just go out and buy a product like that and that it's going to deliver the income that they need to deliver, because everybody's situation is so unique."

Culloton believes that the continuing principal payouts are a short-term drawback that should wash itself out. But his attitude is that the product is still too young to be judged a total success or failure.

"It's only been a couple of years, and it was a couple of rough years, but there's a lot of good things going on here," he says. "Their asset allocations haven't seemed that unreasonable or have not seemed reckless, I'll say that. And the expenses are very low.  But it's still a very new, very untested concept."