One of the key benefits that annuities can provide investors is a guaranteed stream of income for life. But this guarantee comes at a cost, because the investor effectively forfeits control of the money in return for the income guarantee. Mutual fund companies have therefore sought to compete with annuities by creating managed payout funds that also provide streams of income, although they are not guaranteed.
How They Work
Managed payout mutual funds are income funds that are designed to provide investors with equal and predictable monthly payments, similar to annuities but with some differences. When interest rates are low, these funds will try to provide yields in the 1% to 5% range. When rates are higher, they aim for yields in the 8% range. The investor’s monthly payout is determined by the amount of time left until the target date is reached and the fund’s performance in the interim.
However, immediate annuity payouts will generally not rise with inflation, unless a COLA rider is available in the contract. Managed payout funds are more likely (though not guaranteed) to rise with inflation, as this is normally accompanied by a rise in interest rates. Their yields will float with the markets instead of remaining constant. Of course, they cannot provide an ironclad guarantee of income and may lose principal. but they also allow investors to access their principal if they need to, which is virtually impossible to do with an annuity once the payout has begun. Managed payout investors have daily access to their money, as shares can be sold for cash at any time. (For more, see: Who Benefits from Retirement Annuities.)
The question that advisors have to ask is whether these funds can provide superior payouts to comparable annuity contracts. Immediateannuity.com shows that a couple who invests $100,000 in an immediate annuity contract could get $430 a month as long as one of them is living. This would obviously be a better deal than Vanguard’s fund could provide, assuming that the insurance carrier remains solvent.
An example of this is the Vanguard Managed Payout Fund (VPGDX), which has the objective of providing a 4% payout to investors. The fund has a current yield of 3.76%, and a $100,000 investment in the fund would provide investors with a monthly payment of about $313. It requires a $25,000 minimum investment. Charles Schwab Corp. also manages three payout funds, a moderate payout fund (SWJRX), an enhanced payout fund (SWKRX) and a maximum payout fund (SWLRX). (For more, see: Are You Buying Annuities or Mutual Funds?)
Fidelity Investment’s managed payout funds differ from their competition in that they are designed to exhaust the investor’s principal by the target date in the fund, which they try to target around 20 years from the initial investment. They offer this through their Fidelity Income Replacement Funds.
Why Investors Choose Managed Payout Funds
Taxes are another issue to consider. An annuity payout will consist of a mix of return of capital and interest which is taxed as ordinary income. The income from a managed payout funds can be a mix of return of principal, interest, dividends and long and short-term capital gains. Investors may pay tax at different rates on each type of income received.
Investors usually look to managed payout funds for three reasons. Some are unsure about the financial stability of annuity companies, while others cite investment costs and liquidity restrictions as key issues. “Mutual fund companies are trying to understand what clients want in a monthly income product. Their goals of having high income and managing volatility can be at odds with each other,” Omar Aguilar, the CIO of Equities at Charles Schwab Investment Management told Investment News.
The Bottom Line
Despite the advantages that they offer over annuity contracts, managed payout funds have been slow to catch on with investors. The income generated from these funds is often less than that of a comparable annuity contract, and their lack of principal and income guarantees mean higher risk as well. (See more: Annuities: How to Find the Right One for You.)