To some people, thinking about investments is the height of tedium. To others, the topic is too intimidating or complex to master. It’s particularly daunting for those close to retirement who have no pension to look forward to, and who need to convert their assets into a stream of income.
Retirement income products
Among the financial institutions scrambling to provide solutions are mutual fund firms. Some are offering individual investors a new breed of target-date funds that focus on providing retirement income.
Mutual funds managing paychecks
Most of these newfangled retirement income funds have sprung up only within the last three years, and there’s a great deal of variability within the category. Because there’s no standard nomenclature for them, discussing mutual funds designed to pay out retirement income over time can be more than a little confusing.
One type of retirement income fund is actually a static asset allocation fund. They are typically the end of the road in a target-date series.
Because they don’t offer a payout, those types of funds are excluded from the retirement income fund category put together by Lipper, an investment research company.
The funds that Lipper considers to be within the rubric of retirement income funds include those with appropriate asset allocations for retired investors that also pay out money over time.
“We designed this classification to identify funds with professionally managed drawdowns — that is, funds that provide an allowance of sorts to the investor,” says Tom Roseen, senior analyst and research manager for the U.S. and Latin America at Lipper. “So the investor is not only depending on the manager to asset allocate and diversify, but also provide drawdown expertise to the investor.”
The category now has $1.1 billion of net assets under management and growing.
Two types of retirement income funds
According to Roseen, the 30-odd funds in this category can be divided into two subsets: perpetuity and nonperpetuity. The majority are nonperpetuity funds that offer regular payments over a specific time.
Nonperpetuity funds will have an end date at which point all of the money will be paid out, earning them the unofficial moniker “target-death funds.”
“You could look at it as an annuity replacement-type vehicle,” says Certified Financial Planner Nick Withrow, managing advisor with BKD Wealth Advisors in Kansas City, Mo. “Its goal is to provide a stream of income over a known number of years.”
On the other hand, perpetuity funds are designed to last as long as possible. Withrow likens their strategy to that of a university endowment. Rather than exhausting the principal, these funds will try to maintain or even grow your nest egg over time while distributing income. Because they try to preserve investors’ principal, funds that pay out in perpetuity offer smaller payout percentages than their nonperpetuity counterparts.
According to Roseen, the three-year average annual return through May 2011 for the category of retirement income funds was 3.15 percent. See the complete list of retirement income funds, courtesy of Lipper.
Assessing retirement income funds
Funds that make regular payments could be part of a retirement solution for many investors, but there are some key considerations.
When assessing funds, investors need to be sure they’re not comparing apples and oranges. The first hurdle is choosing between funds with a targeted end date and those that pay out forever.
To compare the nonperpetuity target-date funds, group similar target years together. Like target-date funds intended for the accumulation phase of retirement planning, the investments within these funds will become more conservative as their end date nears.
To compare similarly dated funds, “look at their glide path,” says Roseen. A glide path is the progressive change in asset allocation over time.
“Generally, they will tell you how much they are going to have in equity and fixed income and money markets over a certain period of time,” says Roseen. “If they have a large amount of equity and you’re saying, ‘Gosh, I just don’t like to have that much of an aggressive portfolio,’ you may want to choose one that has a higher portion of fixed income.”
To compare funds that make payments for as long as possible, or in perpetuity, as Lipper defines them, investors should evaluate the asset allocation of the funds in addition to the level of distributions the fund is targeting. The annual distribution rate is generally a moving target and isn’t guaranteed, but it can give you an idea of how much income the fund may provide.
Currently there are more retirement-focused mutual funds with a targeted end date than funds that pay out forever, says Roseen. Lipper counts nine unique perpetual retirement income funds and 22 unique nonperpetual retirement income funds. Many of these funds have other share classes with different fee structures as well.
The cost of owning the fund is another important point to compare.
When buying any mutual fund, investors should be aware of the load, or sales commission, to be paid upfront or over time, which will eat into principal.
Annual expenses will take a bite out of your principal every year as well, which will lower the payout slightly. Because many retirement income funds are “funds of funds” — meaning they are composed of several mutual funds — the total expense ratio will reflect the costs of the marketed retirement income fund and those within the basket.
“The average net prospectus expense ratio for retirement income funds is 0.94 percent — that includes direct and indirect expenses for funds of funds,” says Roseen.
Retirement income fund investing strategies
The best way to use nonperpetuity funds may be by laddering several funds that expire over varying time frames.
“Pick several dates, let’s say 2020, 2025 and 2030. I wouldn’t put it all in one year because the way they weight the asset mix is based on those targeted dates,” says Dan Yu, managing director of EisnerAmper Wealth Advisors in New York City.
The way the fund’s allocation will change over time can impact your financial picture, particularly if you live a long time.
Depending on the fund and the strategy it uses, motivated investors may be able to replicate the approach on their own. For instance, the PIMCO Real Income Fund ladders Treasury inflation-protected xecurities, a very accessible strategy for most people.
“A lot of people find what we do boring or complex or uninteresting, but they know they need some management of it and these funds might be the way to do it,” says Yu. “But most people with a basket of index funds or ETFs could do the same thing. They very quickly and easily could do it.”
Bankrate’s story, “Generating income from $500,000,” showcases how Yu and two other financial advisers might design a portfolio worth a half-million dollars for a 70-year-old client.
For people who don’t want to do it themselves and don’t have a relationship with an adviser, retirement income funds could be a happy-medium way of getting professional investment management and regular income payouts. Though they seem like they could be an integral part of the retirement income solution, only time will tell if these funds will live up to their promise.