Funds Move to the Next Level
Mutual funds have been the star of the show in retirement savings plans’ accumulation phase, and a new generation of products appears to have opened up a role for them in the drawdown phase as well. The investments are all varying shades of the same basic idea: mutual funds with a systematic withdrawal plan. These funds of funds, usually referred to as managed payout funds or retirement income funds, stand out from the insurance-based retirement income products on the market because they lack one very notable attribute: a guarantee.
Some industry voices hail the new offerings for their low cost and flexibility (you can cash out at any time), but others worry that the lack of guarantee is not suitable for every situation—a point underscored by recent market volatility. Meanwhile, the way the funds will fit into the retirement income business of advisers is unclear.
Although the funds are regular mutual funds, fund managers say the funds are positioned specifically for the distribution phase rather than the accumulation phase, in that they consist of portfolios of funds that are actively managed to produce an income stream for varying lengths of time. Though not positioned for accumulation, the funds do have upside potential, and some funds consider capital appreciation a secondary goal to distribution. Depending on how the portfolio is constructed (to deplete the principal or to maintain a significant amount of the principal investment), they aim to provide 3% to 12% payouts of the fund assets or initial investment annually; however, each fund administrator has a distinct goal, each better suited for a specific type of investor.
For instance, Vanguard’s Managed Payout Funds do not intend to distribute the entire principal over the payout period, but rather seek to maintain a significant amount of the principal indefinitely. The funds operate in an endowment-like strategy for investors who want access for various reasons, such as legacy or in case of emergency. On the other end of the product spectrum, Fidelity’s offering targets a distribution date by which it will exhaust the principal investment—like a target-date fund in reverse.
John Ameriks, Head of Vanguard’s Investment Counseling and Research Group, says Vanguard saw an interest from investors in maintaining the principal as much as possible. “For some investors, another approach might make sense but, for the vast majority of people, there really was a preference for maintaining a significant amount of the fund for a long time,” he says.
The Marketplace
The Vanguard Managed Payout Funds are intended for initial investment around age 55 to 70 (although there is no minimum age) by those looking for a disciplined way to withdraw their accumulated savings. The three funds (Growth Focus, Growth and Distribution, and Distribution Focus) offer monthly payouts based on the number of shares an investor owns and fund performance. The Growth Focus fund has the highest growth potential and lowest monthly distribution. The estimated expense ratio is 57 basis points and the minimum investment is $25,000. For instance, if you invest $100,000, Vanguard estimates that the initial monthly payout would be $380 in the most growth-focused fund and $843 in the distribution-focused fund—based on distribution rates for 2008. At the time of publication, Vanguard had not yet announced the 2009 prices, but said on its Web site: “Payments are recalculated every January based on the funds’ average share price over the past three years or since inception, whichever is shorter.”
The Fidelity products offer the largest suite of funds available right now, with 14 funds with target-payment dates every two years from 2016 to 2042. The payments are distributed monthly, and are recalculated each year based on a target rate (based on market performance and how many shares owned), in order for the principal to be distributed by the target-payment date. Dan Beckman, a Vice President at Fidelity Investments Institutional Services, says Fidelity is seeing most acceptance of its Fidelity Income Replacement Funds so far in 10- and 15-year strategies. For instance, he says, an adviser could use it as part of a plan to provide income for a set window. “We identified a gap in this particular opportunity—which is to provide payments for a certain period of time,” he says.
Like its competitors, the Fidelity funds are marketed for investors ages 55 and older. The expense ratio is 54 to 67 basis points for institutional funds and an additional 25 basis points for A-share funds. The minimum investment is $25,000.
In addition to Fidelity and Vanguard’s products, other retirement income payout funds that have cropped up in the market between October 2007 and December 2008 include, but are not limited to, offerings from Russell Investments, Charles Schwab, and, most recently, John Hancock Funds.
One main difference among these funds is the intended length of time or payment. What you will find in a prospectus, for instance, is that some funds have varying degrees of disclosure about the asset allocation and how payment distributions can change. Chad Runchey, Actuarial Advisor at Ernst & Young, says some funds (like the Russell LifePoints Funds, Target Distribution Strategies) might tell you the payment distribution and then take control of the assets without disclosing as much about the allocation, while others (like Fidelity) might disclose the allocation but do not tell you exactly how the scheduled distribution payments will change with the market. In line with that, in order to find the correct fund for an investor, keep in mind how much of a payout the investor needs, and work backward to find the right fund, says Jeff Tjornehoj, Senior Research Analyst at Lipper. Some of the funds, such as Fidelity and Vanguard, feature Web-based calculators to help determine how much investors can receive.
The Schwab Monthly Income Funds, like Vanguard’s funds, are designed to provide monthly income without chipping away at the principal investment. “We really felt that there was an appetite within the market to have an evergreen monthly income type product,” says Patrick Waters, Director of Retirement Investment Products for Charles Schwab Investment Management. The funds have three payout strategies of income, starting with 60% fixed-income and 40% equity exposure (lowest monthly payout at 3% to 4% of net asset value) and 90% fixed-income and 10% equities (highest monthly payout at 5% to 6%), with the cost ranging from 61 to 76 basis points. Basically, an investor can take on more risk with the possibility of growth and accept less of a monthly payout, or have less chance of growth and accept a higher monthly payout. The minimum investment is only $100, and Waters says investors are predominantly 55 and older, but the fund has no minimum age for investment.
The Russell LifePoints Funds, Target Distribution Strategies, offer 10-year and 20-year funds intended to provide annual payouts consisting of income from dividends and interest, capital gains, and, if necessary, a return of capital. The funds aim to maintain and even grow the principal, like some of the other products. Although accessible to any age, the funds are targeted for investors 57 and older, says Timothy Noonan, Managing Director at Russell Investments. He says the funds typically are targeted to investors with $500,000 to $3.5 million in investments (although there is no minimum investment).
Noonan says the funds can be helpful in providing an income stream while delaying annuitization as long as possible. “How do you design an investment strategy that will design the lowest probability of destitution? The way that that’s done is by maintaining a balance in the nest egg which, at any given time, would be enough to annuitize if you had to annuitize, but deferring that annuitization decision as long as you can,” Noonan says. The net expense ratio for these funds ranges from 99 to 116 basis points for S-share funds—available through fee-based advisers and retirement plans with no minimum investment—and 128 to 134 basis points for A-share funds, which also have no investment minimum. A notable difference about Russell, says Tjornehoj, is that its funds aim for a specific distribution amount, rather than a percentage of the initial investment.
Relatively new to the market is an offering from John Hancock Funds, the Retirement Distribution and Retirement Rising Distribution funds, which both provide quarterly payouts. The A shares have an expense ratio of 125 basis points and the minimum investment is $50,000. Retirement Rising targets an annual payout of $0.40 per share and intends to have the payout increase with inflation; the Retirement Distribution targets a $0.60 per share payout indefinitely. “They’re designed to have a sustainable long-term payout in perpetuity that’s better than what most individual investors would likely be able to do on their own,” says Andrew Arnott, Senior Vice President of Product Development for John Hancock Funds.
Adviser Competition?
What Arnott says points to the do-it-for-me theme of these products. Yes, anyone could do what these funds do, if he had the discipline (or the adviser) to do so. “If you have the attention and the ability to go online and talk to people about making a payout yourself, then you wouldn’t really need these programs,” says Lipper’s Tjornehoj. The draw of these products is that a lot of people do not want to do it themselves—or, perhaps, with an adviser.
Arnott also contends not only that these are good for people who do not want to manage a systematic payout on their own, but also that there is value in the fact that the funds are positioned for retirement. “Most advisers are simply taking systematic withdrawals from their clients’ portfolios to fund retirement…generally that’s a suboptimal way of creating a sustainable distribution stream,’ he says. With these payout funds, the manager is optimizing a mix of managers around a distribution goal, Arnott says.
Does this solution actually compete with the advisers? Although asset managers are producing packaged retirement income products to capture rollover assets, advisers are not necessarily using them, according to research from Cerulli Associates. The majority of advisers (68%) are not using packaged retirement income mutual funds, and only 6% are always using them. Cerulli notes that both Vanguard and Fidelity are marketing these products directly to the mass affluent investor, evidenced by the calculators on their Web sites.
It is true many of these products are available directly through providers, but they also are available through advisers. Beckman says Fidelity designed its product to mimic some of the art an adviser creates client by client in a withdrawal strategy, and put that into a packaged solution that might help advisers free up part of their business. For instance, this could allow advisers more time to devote to holistic planning, such as tax management. “We’ve looked at how the adviser’s role might need to shift in distribution to cover sort of a wider array of the investment needs and, as a result, they need to be more efficient in certain parts of their business,” he says.
Ernst & Young’s Runchey says that, to some extent, this is a self-directed solution that an adviser usually might do, but this actually could provide another tool for advisers, rather than displace their customizable value. “[Managed payout funds] have a role, especially for individuals who want someone to manage a portion of their assets,” Runchey says. “One of the big keys is having someone who tells you what amount of money you can take out. I think that is something that is lacking in the financial adviser market and as general knowledge for individuals.” Similar to the reason people use target-date funds, the real advantage of these products is in the “ease of use,” Runchey says.
Lipper’s Tjornehoj notes that these low-commission products (compared to an annuity) particularly work well for fee-based advisers, which is where most advisers are headed these days. He says it is especially optimal for clients looking for a low-cost solution, or for clients who are relatively low maintenance. The products do their job in simplifying the process at retirement; however, he points out that annuities, with their guarantees, are a more surefire route to fulfill income needs, especially in light of the recent market conditions. “If you really want that steady income and you’re willing to pay for it, then an annuity makes better sense,” Tjornehoj says.
David Macchia, President and CEO of Wealth2K, a software and media company for the financial services industry, agrees that a guaranteed income product might be the better route for many. “[Managed payout funds] fail at the most basic level in terms of the need to generate a floor of retirement income,” says Macchia. “I think they can be useful, but only as part of a larger and more strategic retirement investment strategy.” The current financial environment will lead advisers to prioritize issues in retirement income that are not usually discussed—for instance, the psychological need for a guarantee, he says.
“If you are using a systematic withdrawal strategy and we’ve had a major decline as we’ve had recently, it’s very difficult for a client to not panic,” Macchia says. It borders on dangerous if the marketing machines behind retirement income funds do present managed payout funds as a comprehensive retirement income solution, continues Macchia. “Where I get concerned is where investors might look to these vehicles as a “solution” to their retirement investment needs,” he says. The products are relying entirely on the market, so, if the share price goes down, what the investor receives suffers, like any other mutual fund.
When asked about the concern that these products do not provide a guarantee, some providers say they expect their products to be used as part of a larger retirement income plan, as opposed to becoming an all-encompassing strategy—for instance, by serving as a complement to, rather than a substitute for, annuities. “My expectation is that our product will be nestled in with annuities in a very cozy way in client portfolios,’ says Russell’s Noonan. He says advisers might use the size of the client’s surplus—or what they have left when their basic needs are met—to determine which product to use. Noonan says a retiring couple that has just enough money in its nest egg might be better off in an insurance solution, while those with money far beyond their basic needs adopt the “self-insured” approach. Noonan predicts that a portion of income that is absolutely required could be annuitized, and the surplus could go into an investment-oriented product like the Russell offering. “I really think that you’ll see combinations—hybrid solutions where there is a portion of the nest egg annuitized and then more innovative approaches to dealing with the surplus to try to get more capital appreciation,” he says. The appealing thing about putting some wealth into a payout fund, rather than 100% into an annuity, is the lower cost and flexibility.
Schwab’s Waters says the big difference between retirement income products and annuities is the guarantee; the tradeoff is expense. “At the end of the day, he says the question would be: Can you handle volatility and fluctuation in your monthly income stream?” If the answer is no, an annuity might be a better choice, he says.
Investor Uptake
So far, it is yet to be seen how the market will respond to the idea of managed payout funds. Few fund managers have accumulated much in the way of assets to date, save Vanguard, which has as much as $115 million in its Managed Payout Growth and Distribution Fund since its May launch, according to Lipper data through October. Fidelity, which was one of the first funds on the market in the fall of 2007, has garnered a few million in assets in some of its funds. The funds have, of course, not been immune from the financial crisis: Their year-to-date returns at the end of October showed drops of about 20% to 30%. However, the silver lining is that most of these funds invest in high dividend-paying stocks so, even if the price is down, the dividends might not be, Runchey says. While most of the funds might be investing in income-generating stocks less sensitive to the market, asset managers still might be faced with a tough decision about whether to cut payment amounts, he adds. The funds leave the option open in their prospectus, and a few already have released addenda announcing recalibrations for 2009 payouts.
Even though the funds are reasonably priced compared with other mutual funds, advisers should still look out for the fees, says Tjornehoj. For instance, be mindful of the prospectus and whether fees can be raised. However, in light of the fact that assets have not grown and, in some cases, actually have dropped, Tjornehoj expects the fees will remain where they are for now, as providers hope to help the funds gain traction in the marketplace.
As of now, although these funds can be positioned as out-of-plan rollover solutions, retirement plan sponsors are not completely on board—which, to be fair, is true of many retirement income products at the moment. Ameriks says Vanguard has discussed the idea with plan sponsors “but there’s not a big rush to get them into retirement plans. There are a lot of folks that are interested, though.” He adds, “There are some plan sponsors that believe very strongly that they need to play a role with their retirees in retirement.”
Noonan says, theoretically, the Russell product could become a norm for retirement plans, just as most retirement plans are offering a target-date fund. “I expect that more and more retirement plans will introduce income funds onto their platforms, but we’re not seeing it quite yet,” he says.
Illustration by Koren Shadmi