As more traditional pension funds are fazed out by employers, it is becoming increasingly important for investors to seek ways to build savings to support themselves without assistance from an employer or the government. Current retirees, and those that will follow, want their investment portfolios to provide a steady stream of retirement income. The financial services industry has responded to these needs by developing targeted-distribution funds. These are mutual funds that provide retirees with a relatively steady stream of income similar to an annuity, but with the flexibility to sell the fund when you need to.
In this article we'll introduce the concept of targeted-distribution funds and will discuss the advantages and disadvantages that should be considered before incorporating these vehicles into any retirement plan. (For five steps to help you replace an employer pension fund, read Chipping Away The Pension Freeze Trend.)
Targeted-distribution funds are also referred to as open-end managed-payout funds. Open-end simply means that they are mutual funds, and can be bought and sold on a daily basis, unlike closed-end funds. The initial wave of targeted-distribution funds come in two main varieties:
- One version seeks to provide a specific monthly payout in dollars and cents.
- Another seeks to provide a percentage of the assets in the account.
While both of these approaches can and have been implemented by individual investors in their own portfolios, these funds provide professionally managed portfolios specifically designed to deliver predictable payouts. The idea being that the fund managers will adjust the portfolios, taking more aggressive positions during difficult markets, for example, to meet the desired payouts.
In funds designed to generate a specific dollar amount each month, the portfolio seeks to generate a specific rate of return in order to meet the desired cash flow requirement. As mentioned above, the strategy is adjusted based on market conditions, taking a more aggressive approach when good returns are hard to find and scaling back the level of risk when markets are better.
In funds designed to provide a percentage of the underlying assets, a target date is set (for example, 20 years after the year you stop working), and the portfolio's earnings and underlying principal are slowly returned to you over the course of the time period. Each year, the amount of the monthly payment may change, based on the amount of money in the account and the portfolio's performance. When the end of the time period is reached, the balance in your account is zero. In these portfolios, the mix of underlying investments begins with a larger weighing toward stocks and shifts towards bonds as the years pass.
Advantages and Disadvantages
- Boon for the prepared - For investors that have more than enough money on hand to meet their retirement needs, this concept works well. The version that pays a steady income without touching the principal is particularly attractive because it provides steady income while leaving the underlying assets for your heirs. Both versions provide instant access to your entire balance simply by selling the fund, unlike annuities, which restrict access to your underlying investment. (To learn about the dangers of annuities, read Watch Your Back In The Annuity Game.)
- Fragile nest eggs beware - Retirees, like everybody else, face bills that require a set amount of money be paid at a set time. Nobody gets a utility bill or grocery bill based on a percentage of their monthly income. For investors relying on small portfolios with little room for error to fund their retirements, the concept of linking distributions to a percentage is rather dangerous. Getting a certain percentage of your assets sent to you each month is more than likely going to result in either taking too much money out of your portfolio or not giving you enough money to pay your bills. While too much might not be a problem, as it can always be reinvested, too little is definitely a problem. (For added insight, see Managing Income During Retirement.)
Those seeking to build a massive nest egg to leave to their heirs are unlikely to be happy with any version of this product. After all, the funds are focused on providing income, so they are unlikely to grow significantly from the amount of the initial investment even when they are structured to make payments without depleting the underlying principal.
The development of targeted-distribution funds is still in its infancy, but it's an idea with an appeal that is hard to deny. The goal is to provide a steady income for retirees, but it is important to realize these products are like any other investment and there is no guarantee that the desired income will be delivered. When the next wave of these new funds hits the marketplace, an underlying annuity or other type of insurance is likely to be in place to meet the desire for consistent, predictable income. For investors who wonder how they will ever be able to afford to retire, the prospect of a guaranteed source of income is certainly an attractive idea.
To learn about similar retirement-focused funds, see The Pros And Cons Of Life-Cycle Funds.