'Coupon-Clipper' Funds Emerge

Since the fund began operating in March, the share price has dropped from $10 to $8.03. But retirees relying on Schwab for income may not feel the need for belt-tightening. While the share price has fallen, the payouts have climbed as stock yields increased. The monthly dividend payments per share have risen from 3 cents over the summer to 3.2 cents now.

Schwab has been able to maintain the income stream by owning a diversified mix of foreign and domestic dividend-paying stocks as well as bonds. Holdings range from Treasury securities to foreign real estate investment trusts, or REITs. "The yields are upwards of 10% on Australian REITs," says Jeffrey Mortimer, chief investment officer of Charles Schwab Investment Management. "As the market gives us more yield, we can increase the payout to shareholders."

Like the Schwab payout fund, Vanguard Managed Payout Growth(VPGDX Quote) owns a diversified portfolio of stocks and bonds. But instead of automatically paying out stock dividends and bond interest payments, the fund distributes 5% of assets annually.

The fund pays the same percentage each year, regardless of how markets perform. The monthly payments can be supported by stock dividends. But if necessary, Vanguard may be forced to sell holdings to maintain the fixed payments. To make the monthly payments this year, the Vanguard fund had to dig into principal, giving shareholders a return of their capital.

For long-term investors, either the Schwab or Vanguard funds can be effective. But there are clear differences. Many advisers prefer reinvesting dividends as the Vanguard fund does. At the beginning of each year, Vanguard determines payments and sends out the same-sized check for the next 12 months. The following year, the payments are again adjusted based on the fund's asset values.