Designed to liquidate completely by a chosen end date, income-replacement funds produce income by gradually returning your investment plus earnings until that target date. Market performance ultimately decides the amount of your monthly payout and whether it's all principal or principal plus earnings.
Managed payouts differ a bit from income-replacement funds and are designed to provide monthly income while growing your initial investment. However, depending on how the stock market fares, the fund might dip into principal to meet its target payout goal.
More funds than meet the eye. So what do you get when you sign up for a retirement income fund? Like target-date funds, retirement income funds allocate assets across a variety of other, usually in-house, mutual funds. For example, if you put money into the MFS Lifetime Retirement Income Fund, you're actually investing in about 20 underlying MFS mutual funds. Investors automatically get exposure to value and growth stocks, emerging markets, commodities, real estate, and bonds. This built-in diversification appeals to many investors who don't want to spend a ton of time thinking about how to divvy up their assets among different types of stocks and bonds as the market changes.
"You get all of this broad diversification within one product and you don't have to build it yourself," Joe Flaherty, an MFS retirement series fund manager says. Although the asset allocations of retirement income funds are generally fixed, managers can make minor changes to the portfolio based on the markets environment, Flaherty says. "You don't have to worry about getting caught up emotionally in what's going on in the markets or forgetting to actually do anything with your portfolio as it gets out of line," he says. "That's the set-it-and-forget-it nature of the product."
Guaranteeing a lifetime of income. A big factor in determining whether a retirement income fund is right for you comes down to how much of a guarantee you want on the payments you receive. It also depends on what sort of income stream you have going into retirement. Historically, retirees have looked to income annuities (also known as immediate annuities) to guarantee fundamental expenses such as mortgage payments and groceries. Paul Horrocks, vice president of the Individual Annuity Department at New York Life, describes an income annuity as a personal pension. "You are buying a stream of income," he says. "You're getting paid [by the insurance company] every year as long as you live. That way you know, no matter what, that you don't have to worry about being unable to pay your rent or buy food or whatever else you need in retirement."
But Horrocks stresses that annuities are not a universal solution to the often complex retirement planning puzzle. "We would not recommend to anyone putting all of their assets into an income annuity," he says. "You should cover your basic expenses with guaranteed sources of income but you might want to use a target-income fund for your discretionary expenses." In other words, if your target retirement income fund performs poorly one year, you might not be able to swing that vacation to Bali, but if you have an annuity you'll still be able to make your mortgage payment.
Know the risks, know the rewards. Dr. Alicia Munnell, professor of management sciences at Boston College and director of the school's Center for Retirement Research, says the toughest part about entering the retirement phase is deciding how to make a lifetime worth of savings, investments, and 401(k) proceeds last long enough. But she also says the pseudo-science behind retirement planning is churning out tools for retirees faster than ever. "All of us are going to face a big challenge on how to draw down our reserves and we're going to need products like annuities or these retirement income funds," says Dr. Munnell. "Firms are stepping up and making these products available, and that is a positive development."