NEW YORK (
) -- Suppose you are a retiree with $500,000 invested in mutual funds, and you need $2,000 a month to live.
To insure a reliable income stream, you must make a series of complicated choices. First you must pick funds that can generate enough income to last for years. Then you must monitor the portfolio carefully. If the market tanks, you may need to reduce your withdrawals.
To offer a simpler solution, money managers have developed managed payout funds. These diversified portfolios make monthly payouts and adjust them to account for market fluctuations. Companies that have begun offering the mutual funds in the last several years include Fidelity Investments, Vanguard Group, and
. So far the funds remain a niche product with only $800 million in assets. But that could change as millions of Baby Boomers retire and look for convenient ways to obtain reliable income.
With markets rising lately, the payout funds have been recording solid returns and making scheduled payments. But shareholders should be aware that the income payments are not guaranteed. Prolonged bear markets could erode returns and result in lower monthly paychecks.
Among the most conservative choices is
Schwab Monthly Income Moderate Payout
. The fund seeks to pay out 3% to 4% of assets annually. To generate income, the portfolio keeps 60% of assets in cautious bond funds. The rest of the payout fund's portfolio is in dividend-paying stock funds.
Schwab's portfolio managers aim to generate enough interest and dividend income to cover all the monthly payouts. The idea is to avoid touching the principal. This cautious approach is different from many competitors who aim to achieve strong total returns by focusing on stocks. "Our goal is to provide a steady payout to our clients -- and not necessarily to deliver higher total returns than our competitors," says Omar Aguilar, chief investment officer for equities of Charles Schwab Investment Management.
Because of its big bond stake, the Schwab fund has excelled in downturns and trailed competitors in rallies. During the last three years, the fund returned 13.4% annually, lagging 63% of retirement income funds, according to Morningstar.
Vanguard Managed Payout Growth & Distribution
takes a more aggressive approach. Vanguard aims to earn big enough total returns so that a retiree can withdraw 5% of assets each year without eroding the principal value of the investment. To meet the goal, the fund has 72% of assets in stocks.
Lately the fund has been achieving strong results, returning 19.7% annually during the past three years and outdoing 94% of retirement funds. But Vanguard's stock-heavy approach comes with clear risks. In the last six months of 2008, the fund lost 25.3%. As a result, Vanguard had to dip into principal to meet distributions.
Because of the losses, shareholders received less income. Under its distribution formula, the fund always pays out about 5% of total assets. So when the value of the assets dropped, shareholders received smaller monthly payments.
John Ameriks, a Vanguard principal, says that the subpar performance during the financial crisis should not derail the funds. "Even if a fund must return capital for short periods, we can still meet the objectives over the long term," he says.
While Vanguard's funds are designed to generate income indefinitely, Fidelity's funds aim to last until a target date such as 2042 when the portfolios are liquidated. For funds with long time horizons, Fidelity keeps big stock allocations. The funds gradually shift to fixed income as the final date approaches.
Fidelity Income Replacement 2042
has 62% of assets in stocks, while the fund that terminates in 2016 only has 20% in equities. Throughout the lives of the funds, Fidelity seeks to keep the monthly payouts relatively steady.
To accomplish that, the portfolio managers follow a careful formula. For a fund that is 35 years from termination, Fidelity pays out about 4.75% of assets. Then as the termination date approaches, the fund pays out a greater percentage of assets. When the retiree is 10 years from the final date, the fund would pay out 11% of assets. "The goal is to provide a steady stream of monthly income while the fund pays out all the assets," says Joe Cullen, a Fidelity institutional portfolio manager.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.