As the baby boomers were saving for their retirement, the mutual fund industry responded with the creation of products to help them accumulate wealth. Now that they are approaching retirement age, the mutual fund industry is starting to focus its attention on the creation of investment products that can create a stream of income to fund retirement. The insurance industry has long used fixed and variable annuities as a means of converting assets into income, and the mutual fund industry has just started to introduce similar products. The classification of products called systematic withdrawal or managed-payout funds help to provide a disciplined approach to a drawdown of assets. (For background reading, see Five Ways To Fund Your Retirement.)
How to Turn Assets Into Retirement Income
As an increasing number of retirees have to rely on their own accumulated savings, it is up to each individual to turn his or her assets into income. Available methods include:
Many people, either by themselves or with the help of an advisor, will come up with their own withdrawal scheme. Those with sufficient funds can live off of the income of their investments without having to touch any of the capital, allowing their capital to grow. The others will have to draw down their capital to provide sufficient income. Most people have no systematic method - they merely liquidate assets when they require the money.
Lifetime Income Annuities
Lifetime income annuities are well-known annuities that provide lifetime payment to the purchaser. Most annuities will provide fixed monthly payments, and some offer inflation-adjusted payments. The monthly income that one receives from a defined-benefit pension plan is in essence a lifetime income annuity. Similarly, Social Security payments can be thought of as a fixed annuity with inflation-adjusted payments. (To learn more, read An Overview Of Annuities.)
Variable Annuity With Guaranteed Living Income Benefits (GMWB)
This type of variable annuity offers a guaranteed withdrawal benefit (GMWB) for life, which provides a minimum payment for the lifetime of the purchaser. This option allows for allocation for stocks and bonds within the variable annuity contract, creating the possibility of an increase in income as well as some protection against inflation.
Systematic Withdrawal Plan (SWP)
Systematic withdrawal allows a shareholder to withdraw money from an existing mutual fund portfolio. With a systematic withdrawal plan, a fixed or variable amount is withdrawn at regular intervals. Withdrawals can be made on a monthly, quarterly, semiannual or annual schedule. Often, a systematic withdrawal plan is used to fund living expenses during retirement. The holder of the plan may choose withdrawal intervals based on his or her commitments and needs.
Types of Systematic Withdrawal Plans
- Capital Retention Systematic Withdrawal Plan (CRSWP)
The goal in a capital retention systematic withdrawal plan is to have fixed payment rates but with the full intention of retaining capital. Typically, these plans will take a fund-of-funds approach, providing the necessary asset diversification.
The Vanguard Group model is one example of this type of plan. It has three different funds, each with a different distribution target: 3%, 6% and 7%. The amount to be paid out each year is based on the payout rate and the average portfolio value of the three previous years. The 3% fund is meant to provide a yearly payout of 3% with a modest increase of growth and income. The 5% plan is designed to provide long-term inflation protection and capital preservation. The 7% fund will appeal to those who need a greater payout to satisfy current spending needs - it is not expected to keep up with inflation. The highest level will provide the highest payout in the earlier years but has the greatest risk of losing capital. If the market performances do not provide enough growth, the funds will liquidate some of the assets to fund the payout. There is no guarantee that the funds will meet their stated objectives of providing income and retaining capital. A weak market will cause a large reduction in income.
- Capital Depletion Systematic Withdrawal Plans (CDSWP)
In this form of plan, the intention is to allow the plan to pay out both principal and accrued income and capital gains by a predetermined date. In concept it is similar to owning a mortgage with a fixed term. The cash flow from the mortgage is a combination of interest and return of capital until the end of the term of the mortgage. In the case of these types of plans, the income is not predetermined like it would be in a mortgage, but is dependent on the underlying investments.
One example of a CDSWP, Fidelity's Retirement Income Replacement Fund, is designed to be a fund of funds. Each portfolio of mutual funds is designed to last 10 to 30 years, with targets at two-year increments. The first one is targeting 2016, and the last one 2036. There will be 11 income-replacement plans in all. This is similar in concept to the popular target-date fund. A feature that is similar to the target-date fund is that the asset mix will change as the fund approaches the target date. The asset mix will become more conservative as the end date approaches and the fund is liquidated. Unlike the target-date fund, the capital will be depleted when the target date is reached. The income is designed to keep up with the rate of inflation, meaning the payment rate will increase as the target date is approached, so the longer the time horizon, the lower the initial payout rate. Income can vary, depending on the performance of underlying investment funds; bad years can result in a drop in income in the following years. The structure is complicated, making it difficult to understand, so if you are considering this type of plan to fund your retirement, you will likely want to discuss your options with a financial professional. (To learn more about this type of fund read, The Pros And Cons Of Life-Cycle Funds.)
The Future of Systematic Withdrawal Plans
SWPs are meant to provide additional choices to the retirement income market. They offer flexibility and liquidity that annuities do not. Unlike an annuity, money can be taken out of these plans at no cost. These plans provide a more repeatable and disciplined approach to withdrawals than a haphazard approach of liquidating investments to provide income.
A growing appetite for these SWP products will mean only one thing: More and more companies will be introducing these products in the future. It is quite likely that each new product will have slightly different features concerning payouts, and different capital retention or depletion schemes. It's also expected that hybrid products will combine different features, like target dates with capital preservation.
Choosing a Systematic Withdrawal Plan
Before rushing to purchase any of these types of products, there are a number of factors to consider. In the end, no matter what the withdrawal scheme, it is important to ensure that the underlying investment funds and the investment strategies are sound and will deliver good performance. The fund that has the feature that is most appropriate for you will not do you much good if the underlying investments perform poorly. Many of these products are very complicated. Not only will there be different payout schemes, but they will employ different investment strategies, with different asset mix allocations and different funds to consider. Also, the expected additional participants in the marketplace might result in a plan that is more appropriate for your unique circumstance.
Study each type of plan to determine whether one might be appropriate for your retirement income needs. Many new products might be reconfigured to make future products more attractive. There is no need to rush to judgment.
The mutual fund industry has started to focus its attention on the creation of systematic withdrawal plans for retirees to help create retirement income from their underlying assets. There are two distinct approaches; one is designed to deplete assets after a certain period of time and the other to pay a constant payout ratio. Each has its own benefits and drawbacks depending on the individual's unique needs. Before rushing into any of these plans, carefully analyze each to find the one that best meets your retirement income needs.