Two mutual funds that offer set payouts and principal guarantees have been launched, with more expected, but financial advisers think the guarantee is flimsy.
DWS Scudder, the U.S. retail division of the asset management subsidiary of
Deutsche Bank AG of Frankfurt, Germany, began offering the funds this month.
What makes them different is a warranty that would protect a fund's ability to provide regular distributions, as well as the return of at least a portion of the principal.
The feature could be extremely appealing to baby boomers on the verge of retiring, who are hunting for a way to sustain income in retirement.
Merrill Lynch USA Bank, an affiliate of Merrill Lynch & Co. Inc. of New York, will provide the assurance.
The new funds join a growing list of managed payout funds, but are the only ones with a warranty.
Fidelity Investments of Boston has no plans to launch funds with a warranty, said Dan Beckman, vice president of product management at the firm. He said that there are plenty of other sources for guaranteed income, referring specifically to annuities.
The Vanguard Group Inc. of Malvern, Pa. declined to comment.
MONEY BACK
John Hancock Financial Services Inc. of Boston, however, has asked the Securities and Exchange Commission for an exemption that would allow it to offer funds with a warranty, said Andrew Arnott, senior vice president with the company.
A mutual fund with a warranty "offers you at least the potential to get money back, where if you annuitize, the money is gone," said Rick Miller, a financial planner with Sensible Financial Planning and Management LLC, a Cambridge, Mass.-based firm with $155 million under management.
Such a product "might make sense for an adviser who mana-ges smaller accounts," suggested Mary L. Van Nostrand, principal with Van Nostrand and Associates Inc., a San Diego-based firm which manages $5 million. Prior to starting her firm, she was an industry consultant.
The DWS LifeCompass Income Fund seeks to make a fixed-dollar distribution equal to an 8.25% annual yield, based on the fund's initial share price of $10. Distributions are made twice a year, and the fund is structured to target its objectives over a 10-year investment horizon.
The fund's ability to provide regular distributions is protected by a third-party financial warranty with Merrill Lynch Bank USA, which helps assure shareholders re-ceive periodic distributions as well as the return of at least a portion of their principal — with no less than 17% returned at maturity.
The DWS LifeCompass Protect Fund is an asset-allocation fund with a 10-year maturity. At maturity, shareholders will be able to redeem shares at the highest net- asset value of the fund.
"We view [these funds] as an innovative solution that gives investors that additional level of comfort," said W. Douglas Beck, managing director and head of products at DWS Scudder.
Not everyone, however, agrees.
While an annual distribution equal to an 8.25% annual yield based on the fund's initial share price of $10 seems enticing at first, the fact that the fund can eat into so much of its principal, leaving just 17% behind, doesn't seem that impressive, said Scott Kays, president of Kays Financial Advisory Corp., an Atlanta-based firm with $150 million under management.
"An investor can do that themselves without a warranty," he said.
Wirehouses such as Merrill Lynch "underestimated their risk in a very big way," with regards to their subprime mortgage exposure, said Mark Balasa, co-president of Balasa Dinverno & Foltz LLC, an Itasca, Ill.-based firm with $1.5 billion under management.
"Are they misjudging this risk as well?" he said, referring to the possibility that the DWS funds might not be able to live up to their promises.
A look at the prospectuses for the two funds, however, suggests Merrill Lynch isn't taking that much of a risk, Ms. Van Nostrand said.
"The guarantee isn't guaranteed," she said.
For example, according to prospectuses for both funds, the warranty provider can limit the portfolio manager's ability to make investment decisions. If the manager violates those limits, Merrill Lynch can terminate the warranty agreement.
However, Mr. Beck said that Merrill Lynch wouldn't have extended a warranty to the funds if it didn't have the confidence that the funds would perform as advertised.
The funds will invest in a novel mix of securities DWS Scudder believes will allow them to meet their goals, he said.
The active component of the funds consists of a managed portfolio of global equity index futures contracts and exchange traded funds to provide potential capital appreciation and generate distributions.
The reserve component consists of a managed portfolio of U.S. government securities, as well as the DWS Short Duration Plus Fund (DBPIX), designed to provide potential capital protection.
The warranty, however, is a sticking point for some advisers.
It cost investors in the DWS LifeCompass Income Fund 0.59% of fund assets, and 0.57% of assets in the DWS LifeCompass Protect Fund.
It contributes to what some advisers said was a rather hefty expense ratio of 1.87% for both funds.
"That's real stiff," said Thomas A. Muldowney, a managing director with Savant Capital Management Inc., a Rockford, Ill.-based firm with $1.5 billion under management.
CHEAPER THAN ANNUITIES
Of course, for those investors who insist on a guaranteed stream of income, the DWS funds are much cheaper than annuities.
The average annual expense on variable annuity subaccounts is 2.37% of assets, according to Morningstar Inc. of Chicago. And that doesn't take into account other fees and expenses that typically go with an annuity, such as surrender charges.
"Insurance has its place, but we think [our funds are] an option for people to consider in lieu of, or as a complement to, annuities," Mr. Beck said.
Considering the thirst retiring baby boomers are expected to have for income, investors can expect to see more such funds, said Howard Schneider, president of Practical Perspectives, an industry consulting firm in Boxford, Mass.
"They may not be here yet, but you can bet other fund companies have similar funds in the works," he said.
But if the new DWS Scudder funds are a blueprint of what can be expected, advisers were less enthused.
David Hoffman can be reached at [email protected].
