You've scrimped and saved, and dutifully contributed to your 401(k) for years. You might be able to depend on Social Security benefits for a little supplementary income, but with some company-sponsored pensions virtually defunct and retirement on the horizon for millions, how can you make sure you don't outlive your nest egg? "As baby boomers get to retirement, more people are going to be in the retirement phase, the draw-down phase," says Peng Chen, president of Ibbotson Associates, an investment consulting firm and subsidiary of Morningstar. "They have to convert their lifetime savings into an income stream."
To meet this need, mutual fund industry giants including Vanguard and T. Rowe Price have created a group of investment products collectively called target retirement funds. The category includes both target-date funds and a relatively new incarnation of the concept, target-retirement income funds. Although they're grouped in the same family as target-date funds, these newer funds have a slightly different structure and goal.
For starters, target-date funds are designed for investors who are 20, 30, or 40 years away from retirement, while target-retirement income funds are designed for people already in retirement. Also, the income funds don't have a specific target date and maintain a static and fairly conservative asset allocation of about 30 percent of total assets in stocks, and the remaining 70 percent in bonds and cash. (With target-date funds, investors get a progressive asset allocation plan, called a glide path, which takes their assets from a greater exposure to stocks to a more conservative portfolio that's heavier on bonds as the target date approaches.)
Getting paid. The biggest difference between the two fund types is that while target-date funds focus on asset accumulation, target-retirement income funds focus on supplying a stream of income (and some capital appreciation) to retirees. To do this, retirement income funds periodically dole out distributions in the form of dividends and capital gains. For example, Fidelity's version, the Fidelity Freedom Income Fund, pays dividends monthly and capital gains in May and December. Investors can either take their dividends and capital gains as a cash payment or reinvest the amount back into the fund (or another Fidelity mutual fund). To get an idea of what kind of payouts you can expect from the these funds, the average 12-month yield for the category is about 2.7 percent, according to Morningstar. As of early October, the Freedom Income fund's yield was around 2 percent.
Despite their reputation for being safer, less risky investments, the performance of these bond-heavy funds still ultimately depends on how the market performs and also on the fluctuation of interest rates for bonds. "As investments go, they are pretty conservative," says Robert Brokamp, editor of the Motley Fool Rule Your Retirement newsletter and former financial advisor. "But in times when you have huge financial stress, they won't necessarily hold up." You can lose money with these investments and payments aren't guaranteed with retirement income funds as they are with a product such as annuities. If the stock market goes south, investors must be prepared for fluctuations in principal and the possibility of reduced distributions, Brokamp adds.
With target-retirement income funds, there's also an opportunity for higher income down the road. When the market rallies or interest rates drop, distributions increase and your investment appreciates, which can make your savings last longer.
What retirement income funds are not. Retirement income funds shouldn't be confused with other income-producing funds such as income replacement or managed payout funds. Although both fund types typically invest in other in-house mutual funds, how they accomplish the goal of generating income for investors differs.