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Retirement Income: Mutual Funds Get in the Game

With its new retirement-income funds, the industry gets off to an intriguing start in helping shareholders 'decumulate.'

Daniel Culloton and Andrew Gunter, 05/30/2008

This article originally appeared in the spring 2008 issue of Morningstar Advisor magazine. Subscribe today.

Pardon our prospectusese, but we've been reading regulatory filings of a new breed of mutual fund, one that aims to help investors draw down their nest eggs instead of build them up--or, in industry parlance, "decumulate" assets instead of accumulate them.

The Biggest Generation
This is a twist for an industry that has spent decades competing for investors' retirement savings, but there are good reasons for it. Paramount among them are the baby boomers (who else?), the oldest of whom will reach retirement age in three years. The boomers not only make up one of the largest generations in U.S. history, but they're also one of the most prosperous.

After years of helping them gather retirement savings, mutual fund companies are loath to let them take their nest eggs (and all the fees they generate) to someone else for help dispersing their hoards.

Brand-New Tools
We've been hearing for years that the mutual fund industry was preparing tools designed to help investors turn their retirement savings into income. More and more of those products are showing up in SEC filings and in fund family lineups. Fidelity Investments last year rolled out its Income Replacement funds. Rival Vanguard will introduce managed-payout funds in May. DWS recently launched its LifeCompass Income fund to provide "protected" distributions for 10 years, and Schwab Monthly Income funds hit the market in March. Other fund families, including John Hancock, Russell, T. Rowe Price, and AllianceBernstein, have their own versions in the works. There likely will be many more, but in this article, we look at some of the initial entries and offer an early read on their pros and cons.

A few general observations before we go on: Though these funds, with their regular income streams, offer the benefit of helping retirees budget and plan as they did when they received regular paychecks, they are not annuities. They don't have the same tax-advantaged elements. And they don't require that investors lock up their money. Investors can buy and sell shares just as they would with any other mutual fund. Also, these funds don't have many of the customizable features that annuities offer, such as guaranteed minimum withdrawals and payouts to spouses. Of course, those features can be confusing, and they cost money. So it's not surprising some of the distribution funds are cheaper than annuities. Furthermore, unlike an annuity, these funds make no promises. Your clients could lose money in them.

Fidelity Income Replacement
Fidelity offers more than a dozen Income Replacement funds, and they're essentially target-date retirement funds of funds in reverse. They offer preprogrammed asset allocations that gradually shift from stock funds to bond funds as their goal dates approach. These funds, however, also allow investors to gradually draw down their principal as the target dates approach by opting to receive a monthly income payment. Investors seeking to cash in part of their nest egg over the next 12 years, for example, would buy Fidelity Income Replacement 2020 FILAX. The absolute value of the distribution might go up if the stock market rises, but it could also go down. If the asset- allocation schemes work, the principal should last long enough to meet payouts until the fund liquidates at its target date.PAGEBREAK

The asset allocation in the Income Replacement funds, which start with a 2016 target date and increase by two-year increments until 2042, seems reasonable. They're more conservative than target-date retirement funds, but they still allocate a healthy amount of assets to stocks. One of the most aggressive funds, Income Replacement 2036 FURAX, has 62% of its assets in equities with the rest in high-grade bonds. The Fidelity funds' minimum investment is $25,000, and their expense ratios range from 0.54% to 1.66%, depending on the share class.

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