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.
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."
Firms such as MFS, Fidelity, and T. Rowe Price have stepped up their efforts to aid the ballooning baby boomer population in recent years, but their experiment is still fairly young. No one really knows what the "right" bond and stock weightings for a retirement income fund are or even what the "correct" mix of underlying funds should be. Only time will tell whether fund managers can balance the often opposing goals of generating income and mitigating risk for investors.