Managed payout funds a tough sell to investors

The funds are more flexible than annuities, but can't guarantee a set payment for life.

Mutual fund companies are trying hard to tap into the guaranteed income market — without actually guaranteeing income — via managed payout funds. How do they stack up against immediate annuities, the go-to choice for many investors who want lifetime income?

Start with the basics. Managed payout funds gear their portfolios to giving relatively equal monthly payments. Vanguard Managed Payout (VPGDX), for example, tries to pay a 4% annual distribution. Currently, it estimates that a $100,000 investment would generate $313 a month, or 3.76%.

Schwab’s Monthly Income Funds offer three options: A moderate payout fund (SWJRX), an enhanced payout fund (SWKRX) and a maximum payout fund (SWLRX). In low-interest environments, the funds try to distribute payments of 1% to 5%. In high interest rate environments, they attempt to reach payouts as high as 8%.

Finally, Fidelity’s Income Replacement funds aim to liquidate your investment entirely by the fund’s target date. The distribution rate depends on the time before liquidation and how well the fund’s investments have performed.

For an adviser, the question is whether these alternatives would be a better selection for a client than an immediate annuity. According to immediateannuity.com, a 65-year-old New York couple could get a lifetime income of $430 a month. Assuming the company remains solvent (and the state’s insurance pool does, too), the clients would get the $430 a month until they join the Choir Invisible.

Let’s take a look at the funds versus an immediate annuity.
• Inflation. The drawback to an immediate annuity is inflation, because the effects of inflation are cumulative. At 2% annual inflation, a fixed payment will lose 18% of its initial purchasing power after 10 years. Managed payout funds, however, have variable payouts which may (or may not) rise over time and compensate for inflation.
• Guaranteed payments. The main draw of an annuity is the guarantee of income for life, which mutual funds can’t offer. Vanguard’s and Fidelity’s offerings note that parts of their payments may consist of return of capital.
• Liquidity. Once you buy an immediate annuity, your options to take out additional money in an emergency can be extremely limited. Funds are convertible to cash at the end of every trading day.
• Taxation. Assuming you bought an annuity with after-tax money, your payouts will be a mix of a return of principal, which is not taxable, and interest, which is taxable at your ordinary income tax rates. Mutual fund payouts will be a mix of capital gains, interest, dividends and return of capital. If funds own futures, those gains will be taxed at a mix of short-term and long-term capital gains.

Because funds can’t guarantee a set payment for life, their payouts sometimes have peculiar twists. Schwab’s Moderate Payout fund, for example, had a distribution yield of 2.48% the past 12 months, while its more aggressive Maximum Payout Fund doled out just 2.17%. The Moderate Payout fund has a higher percentage of dividend-paying stocks in its portfolio than the Maximum Payout fund.
While you can arrange to have some of your annuity payout passed on to your heirs, those features typically reduce your monthly payouts. Any remaining money from a payout fund can go to your heirs.

Omar Aguilar, CIO of Equities at Charles Schwab Investment Management, says that people who invest in Schwab’s Payout funds over annuities cite three reasons: Worries about the soundness of insurance companies, fears of illiquidity, and costs.

“Mutual fund companies are trying to understand what clients want in a monthly income product,” Mr. Aguilar said. “Their goals of having high income and managing volatility can be at odds with each other.” For some investors, a middle ground works best: Using a managed payout fund for the first 20 years of retirement, and purchasing an annuity for their later retirement years, Mr. Aguilar said.

Investors aren’t exactly rushing to managed payout funds: Vanguard Managed Payout has $1.7 billion in assets, but that’s partly because two other managed payout funds were merged into it. Schwab’s payout series range from $100 million to $49 million. Fidelity’s 14 Income Replacement funds range from $29.2 million to $4.8 million in assets. (The Boston-based fund company recently discontinued its adviser class funds for lack of interest).

“Fidelity had so many approaches to the same portfolio construction – lifestyle and asset manager funds – that people got confused,” said Jim Lowell, manager of Fidelity Investor, a newsletter. “I don’t think they would persuade me to think that these products deliver on leave-the-driving-to-us.”

Ultimately, all the managed payout funds have in common is that they offer managed payouts — but they differ on exactly how they do that, noted Jeff Holt, associate director manager research at Morningstar. “They really require an investor to dig in and understand what they’re really buying.” Fund companies, Mr. Holt said, thought of the funds the same way as the baseball field in Field of Dreams: If you build it, they will come. “But they didn’t come.”