Baby boomers will be the first wave of retirees to rely more heavily on their 401(k) balances rather than traditional defined-benefit plans to meet their retirement needs.
To assist these retirees, financial advisers will need new tools and solutions to help turn those nest eggs into sources of sustainable retirement income.
One new set of solutions is a category of mutual funds called managed-payout funds. These funds are designed to deliver a steady payment stream similar to an annuity, while providing the liquidity, transparency, lower fees and simplicity of a mutual fund.
Although product features and investment strategies may vary, managed-payout funds today don't guarantee account balances or distributions the way annuities do. However, according to Mathew Greenwald & Associates' recent 2010 Survey of Financial Advisors, many of the characteristics of managed-payout funds are “very appealing” to advisers.
Such funds can be distinguished by several characteristics:
Distribution policies: The first and most important consideration is the fund's distribution policy, which typically has either a “payout” or “payback” characteristic. A payout policy is designed to pay distributions in perpetuity from investment earnings, much like an endowment fund. A payback policy, on the other hand, is designed to repay its principal over time and has a specific maturity date, at which time the fund closes and remaining principal, if any, is returned.
In order to maintain their distribution levels and avoid returning investor capital, some payout-type funds may reset their payment rates annually within a specified range, such as 5% to 7% of trailing net asset value. By contrast, funds designed to pay back principal tend not to vary their payment rates and, consequently, may return larger portions of capital, depending on investment results.
Investment policies: Another distinguishing characteristic of the managed-payout fund is its underlying investment strategy. Some funds structured as asset allocation or balanced funds look to generate capital appreciation along with steady distributions through broad diversification and attractive risk-adjusted returns. Asset class exposures, gained typically through a fund-of-funds structure, might include domestic and foreign -equities, developed and emerging markets, global real estate and alternatives, as well as core, global and high-yield fixed income. In addition to generating distributions, these funds can also act as single sources of allocation solutions while allowing investors to customize their asset class exposure and risk preferences by adding funds to their account.
Other funds may hold only single strategies such as diversified or emerging-markets bonds, Treasury inflation-protected securities or even high-dividend-paying equities. The choice of these funds for a portfolio should be based on the client's diversification needs and the level of expected income.
Other considerations: In addition to distribution and investment policies, managed-payout funds may also use different techniques to generate and stabilize their distributions. For instance, the use of a call-writing overlay program can generate premium income to support payments and avoid a return of capital when traditional sources of income such as interest, dividends and capital gains fall short.
Although managed-payout funds were designed for retirees, the need and use of the distributions can vary by individual. For retirees, distributions can help support day-to-day expenses or be used to pay the required minimum distribution from an individual retirement account. For pre-retirees who don't need current income, distributions might be reinvested to help build their future retirement income stream.
Although advisers may find managed-payout funds appealing, the Greenwald & Associates survey also showed that only 32% of advisers surveyed said that they are either familiar or very familiar with these funds. As with any new investment strategy, advisers need more education about these funds and their potential as solutions for their clients.
As advisers adapt to the evolving needs of their aging client base, managed-payout funds are becoming a promising part of the solution by offering a dependable source of income, diversification and generally better liquidity, flexibility and transparency than annuity contracts. Advisers who recognize these benefits will have another powerful tool to help clients meet retirement goals.
Tom Applegate is a chartered financial analyst and client portfolio manager for ING Investment Management.
For archived columns, go to InvestmentNews.com/retirementwatch