Bruce Christopher has always been a do-it-yourself investor. Since he and his wife, Judy, retired several years ago, they have withdrawn 3 to 4 percent annually from their mutual-fund portfolio for "play money," to spend on vacations and discretionary purchases (the couple lives on a combination of Social Security, pensions, and an annuity). But Christopher wanted to figure out a systematic withdrawal plan rather than sporadically redeem mutual-fund shares throughout the year. In January, he decided to put the portfolio on autopilot. "I got to the point where I thought I needed a little help," says Christopher, 64, who lives in Vonore, Tenn., near Knoxville. He considered converting the account into a target-date fund, which rebalances automatically to include more bonds over time.
In the end, Christopher found a one-shot solution in a new type of fund that combines features of both target-date funds and annuities. Like target dates, Fidelity's Income Replacement funds contain a portfolio of other funds that becomes more conservative as the years pass. But instead of building toward a lump sum at maturity, the new funds gradually return investors' money via monthly payouts and are depleted by a "horizon date." Christopher chose a 2042 horizon, which targets an annual payout of 4.75 percent of the initial investment. So, for a $100,000 investment, the fund aims to distribute $4,750 during the first year (spread out over 12 months). Payouts, which seek to keep pace with inflation, are expected to come from dividends, appreciation, and a portion of the principal. The Christophers can also temporarily suspend the monthly payouts or cash out at any time.
Fidelity is just one of a handful of companies angling to help retirees convert their nest eggs into a predictable stream of income—a process that stumps many investors. "Most people are comfortable with the accumulation phase, but the big question is now on the pay-down side. Now that you've reached retirement, how do you create an income stream to meet your needs?" says Patrick Waters, director of retirement investment products for Charles Schwab, which launches its Monthly Income funds March 28. Of course, investors could set up their own diversified portfolio with a systematic withdrawal plan, but payout funds handle all the guesswork. Russell Investments and DWS Scudder recently rolled out their versions of the funds, and Vanguard and John Hancock are awaiting regulatory approval. More fund companies are sure to jump on board, given the target audience of nearly 80 million baby boomers set to retire over the next two decades.
Choices. These funds take different approaches to the steady-income theme. For example, Vanguard's Managed Payout funds, set to launch sometime in March, aim to function like an endowment and generate monthly distributions without dipping into the original investment. Investors can opt for an annual payment of 3 percent, 5 percent, or 7 percent of the account value, depending on whether their focus is greater income or more long-term market growth. These funds also look different under the hood: Fidelity sticks with a traditional stock-and-bond mix, while Vanguard's funds-of-funds may include more exotic fare like real-estate investment trusts and commodity- and inflation-linked investments. Schwab can adjust the stock and bond weightings in its funds depending on market conditions.
Investors should keep in mind that unlike annuities, these funds don't guarantee their payouts. If the funds don't generate enough income from dividends or appreciation, they may have to dip into the principal or reduce payouts. Fidelity, for example, cautions: "If the market performs strongly in any given year, your payments may increase the next year; poor market performance could lead to decreased payments."
An exception is DWS Scudder, which recently launched two funds that distribute a fixed 8.25 percent over 10 years. Payouts are backed by a warranty from Merrill Lynch and occur twice a year. It's a good idea to approach payout funds as the Christophers have—as a way to supplement retirement. Although companies have back-tested these funds in a variety of market scenarios, says Brad Levin, president of Legacy Wealth Partners, an Encino, Calif., financial advisory firm, "there is no real history we can use as an example and no guarantees of how they will work."