Recently the mutual fund industry has introduced a new type of financial product targeted at Baby Boomers: income replacement funds. Fidelity has initiated several of these funds and Vanguard’s versions of the same idea, known as “managed payout” funds, were rolled out earlier this month. Other companies will doubtless follow their lead; Schwab and John Hancock are reportedly working on similar products. Like any investment product, these funds will be useful for some people. Consumers should be certain that they understand these funds in order to avoid any unpleasant surprises.
Mutual funds have become familiar investment tools for most investors. Within the limits defined by regulatory guidelines, mutual funds can be adapted to fill a variety of investment needs. The two giant fund families are taking different approaches with the income replacement funds they’re creating, though the target markets are the same.
Fidelity’s income replacement funds are similar to “target-date” mutual funds in that their mix of stocks, bonds, and cash will change over time as the investor ages. The funds will be allocated more conservatively as retirement approaches and thereafter. Retirees then take out a specified percentage of the money each month. Fidelity’s promotional material indicates that the idea is that the funds are eventually “spent down” by the retiree.
Vanguard, on the other hand, hopes to structure its funds so that they produce returns that enable investors to make regular monthly distributions from their accounts while preserving the principal (initial investment) indefinitely. Vanguard’s fund allocations will include not only stocks, bonds, and cash, but also commodities-related investments. Moreover, the funds can invest in the Vanguard Market Neutral Fund, which uses a strategy in which analysts seek to buy undervalued securities and short-sell overvalued ones. The fund prospectus also indicates that in the future these funds could invest in a not-yet-created “absolute return fund,” which would seek to generate returns that are not correlated with traditional asset returns. Vanguard seems to be seeking to capitalize on growing investor interest in “alternative” investment classes. The latter two strategies are techniques that have been used by various hedge fund managers for many years, but they are not “guaranteed” ways to make money. The use of these techniques breaks new ground for a mutual fund intended for retirees.
The special quality of both of these funds is that they are intended to pay out a regular percentage of their holdings to retired investors. The idea, in principle, is that the accounts function like a personal pension plan or annuity. Fewer and fewer retirees have pensions, and many people dislike annuities because of the risk that an investor might die before getting all his money back. These mutual funds are being marketed as an alternative to the reliable income provided by pensions/annuities. Of course, you can’t “invest” in a pension; you either have one or you don’t, so these funds are seeking to compete with annuities.
Differences between income replacement funds and annuities
However, the resemblance between these funds and annuities (or pensions) is pretty superficial. Income replacement funds do not provide a guarantee that your income will remain constant over your lifetime. Depending on investment performance and your longevity, your account could run out of money before you die. In contrast, annuities and pensions normally provide continuing payments until death, and some are structured to provide survivor’s benefits as well. As long as the insurance company (annuity) or employer (pension) remains solvent, the income continues, and there are guarantors who stand behind annuities or pensions in the event of a failure. Though these new funds come with warnings that their investment performance may not permit them to meet their income payout goals, these warnings probably won’t be the most prominent aspect of their marketing.
The taxation of income replacement funds is also different from annuity payments. The treatment of gains in an income replacement fund will be determined by where it is held. In an IRA or qualified account all gains will be tax-deferred; in a taxable account, capital gains, dividends, and income will be taxed whenever they are distributed by the mutual fund. Funds in an annuity grow tax-deferred, and payments received are often partly taxable as ordinary income.
One thing that will make these funds attractive relative to annuities is that annuities are usually complex investment contracts with complicated fee schedules. Annuity contracts often come with “surrender fees” which must be paid if the investor wishes to get out of the contract within a specified period of time (this is often as long as seven years after the contract is purchased!). Mutual funds sometimes have similar fees, but these usually are only charged if the shares are sold within six months or so after purchase. But investors who want to use either annuities or income replacement funds will need to be sure that they understand all the consequences of investing in the specific product they’re buying. They must also consider how much income they will need in retirement and how their tax situation is likely to change when they retire.
Income replacement funds are still quite new. It remains to be seen whether these funds will be able to deliver on their implied commitment to provide lifetime payouts to retirees. Investors should not assume that these products offer the same protections as an annuity.
A final caveat: The Vanguard prospectus for these funds refers to the possible future “absolute return” strategy and indicates that “the absolute return fund [into which the Managed Payout funds might invest] may use substantial leverage to amplify the volatility and expected returns of the strategy….” The prospectus also notes that the absolute return fund, if created, would not be a traditional mutual fund or a fund registered under any federal or state securities laws. This sounds like a hedge fund! Presumably only a small allocation of the managed payout fund’s assets would be allocated to this type of fund. Even so, the use of leverage (investing borrowed money) would be unusual for a fund intended to provide income to retirees. Pensions and endowment funds have been investing in these kinds of funds for a while, but they have considerably deeper pockets than individual investors.
Disclosure: I’m not invested in any of the funds mentioned in this post.