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Should You Let Vanguard Handle Your Income Needs?

Vanguard's managed payout funds are useful, but they do have limitations.

Dan Culloton, 07/30/2012

Vanguard's Managed Payout Funds may not be perfect income-producing solutions, but they can be good ones.

The three funds--Vanguard Managed Payout Growth Focus VPGFX, Growth & Distribution Focus VPGDX, and Distribution Focus VPDFX--launched into the maw of 2008's vicious bear market. Losses quickly forced them to reduce their monthly payments and tap shareholders' principal to fund payouts. That unpleasant debut kept investors away. Since then, however, the funds' results and payouts have recovered, lending credence to Vanguard's claim that the endowmentlike offerings and their distribution methods were built to last.

These funds try to turn savings into income streams that won't dry up. They're among the cheapest of a subset of monthly payment funds launched in recent years. Vanguard's funds distinguish themselves by trying to invest like miniendowments to support their disbursements without depleting principal. Rather than piling into higher-yielding securities and letting shareholders live off the distributions, these use Vanguard funds (and some derivatives for commodi­ties exposure) to implement an active asset-allocation strategy that aims to make shareholders' money last while fueling monthly payouts. Growth Focus targets 3% of a hypothetical three-year account value, Growth & Distribution 5%, and Distribution 7%.

As funds of funds they use highly rated funds, such as Vanguard Total Stock Market Index VTSAX, Vanguard Total Bond Market Index VBTLX, Vanguard Total International Stock Index VTIAX, and REIT indexes, to get asset-class exposure. The investment committee tweaks the funds' alloca­tions based on the managers' long-term outlook but does not try to time the market. Overall, the committee, led for now by firm CIO Gus Sauter (CIO-elect Tim Buckley will replace Sauter when he retires in December 2012), has been slightly contrarian and opportunistic. For example, it added corporate-bond exposure via Vanguard Interme­diate-Term Investment-Grade VFICX during the financial crisis and held on for three years. More recently, the relatively more bond-oriented Distribu­tion Focus fund has avoided Treasury Inflation-Protected Securities because their real yields don't look promising. Instead of owning Vanguard Inflation-Protected Securities, the Distribution Focus fund has about twice as much as its benchmark suggests in Vanguard Market Neutral VMNIX, which tries to generate returns that beat the three-month U.S. Treasury bill with low correlations with other markets.

The funds' monthly payouts may catch the eye of investors eager to live off their nest eggs. But note the dollar amounts of the funds' distributions will fluctuate year to year with performance, and the fund can use capital gains, income, and return of capital to fund payouts. The funds' payout rule tries to control principal erosion and simplify the task of adjusting withdrawal rates to market conditions by tying monthly payment size to performance. These funds won't magically transform a small balance into an income stream you can live off indefinitely. A minimum $25,000 investment in the Growth & Distribu­tion fund, for instance, currently generates payments of less than $100 per month according to Vanguard's online calculator. The funds work best for those who already have amassed significant savings.

Note that these funds are not annuities. They can lose money, and their payments can vary from year to year based on their trailing three-year results. The funds also have different risk profiles. Growth Focus is the most aggressive and offers the best chance to generate inflation-beating payment growth, but also the smallest payout rate and most volatility. Growth & Distribution is the middle-of-the-road fund, and Distribution Focus offers the highest payout rate but smallest odds of beating inflation. So far, each of the funds has been more volatile than rival payout offerings, but they've beaten their internal benchmarks since inception and have accrued more gains to fund their payments. There are no guarantees here, but they can be useful tools.

Dan Culloton is an associate director of fund analysis for Morningstar and editor of Morningstar's Vanguard Fund Family Report, a monthly newsletter that offers independent, no-holds-barred guidance on the pros and cons of this dominant fund family. Click here for a free issue of the Vanguard Fund Family Report.

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