Six Things to Mull before Buying a Vanguard Managed Payout Fund

Welcome to the decumulation era. The widely anticipated Vanguard Managed Payout Funds are available for purchase and should begin full operations next week.

These payout funds are among a new breed of mutual fund that aims to help investors draw down their nest eggs instead of build them up--or, in the fund industry parlance, "decumulate" assets instead of accumulate them. They are intriguing attempts to offer endowmentlike investment strategies to average investors, but judging from media and investor inquiries that I receive, I think they're still poorly understood. Here are some important facts to consider before committing a portion of your savings to these new vehicles.

Don't Say Annuity
The payout funds are designed to produce monthly income, but they aren't 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, there aren't many of the customizable features that annuities offer, such as guaranteed minimum withdrawals or payouts to spouses. Of course, those features can be confusing, and they cost money. So it's not surprising that payout funds are cheaper even than the total cost of Vanguard's own low-priced annuities. Most importantly, unlike an annuity, these funds make no guarantees. You could lose money in them.

No Target Date
Some investors mistakenly think that payout funds are a form of a target-date retirement offering. Target-date funds are programmed to get more conservative as a preset retirement date approaches. There are payment-generating funds that take a target-date-like approach. Fidelity Investments' Income Replacement Funds, for example, use asset-allocation schemes to generate monthly payments until a preset liquidation date. However, the three Vanguard payout funds--Vanguard Managed Payout Growth Focus Fund , Growth & Distribution Fund , and Distribution Focus Fund --are different. They also will make monthly payments but do not plan to liquidate. Vanguard's funds hope to earn enough on investor assets to avoid returning capital to shareholders--though that could still happen. The funds will try to let investors live off and grow their assets at the same time.

No Static
The payout funds are funds of funds. Most investors are familiar with the format--mutual funds that own other mutual funds. The payout funds, however, will be more dynamic than static funds of funds like  Vanguard STAR (VGSTX) and even the target-retirement funds. The payout funds are miniendowments that can tap a broader set of asset classes, including stocks, bonds, real estate, inflation-indexed securities, commodities, and alternative asset classes, such as a new Vanguard market-neutral fund. The prospectus even leaves the door open to hedge funds.

Vanguard plans to actively manage the funds' asset allocations to ensure they can meet their payments ad infinitum without dipping into shareholders' principal. An investment committee will use quantitative and qualitative analysis to set and adjust the asset allocations, which will be carried out by the firm's Quantitative Equity Group. The size and frequency of the asset-allocation changes are unknown, but, given Vanguard's penchant for straight-laced strategies, I would be surprised if we saw huge swings month to month or even year to year.

Irregularly Regular
Vanguard's offerings will use a managed-distribution policy under which they will try to make targeted payouts in the middle of each month. The distributions will be the product of the number of shares an investor owns multiplied by the monthly distribution per share, which Vanguard will determine each Jan. 1 based on the funds' prior three years of performance. Vanguard determines the distribution per share like this: They take the annual distribution rate of each fund (3% for Growth Focus, 5% for Growth & Distribution, and 7% for Distribution Focus) and divide it by 12. Then they multiply by the quotient of the average daily value of a hypothetical account in the fund over the previous three years, divided by the number of shares held in that hypothetical account at the end of the previous year.

This means the funds' distributions won't be a fixed percentage of their net asset values or a set dollar amount. They will fluctuate with performance. Growth Focus will be the most aggressive of the trio. It will offer the smallest initial payments but the greatest potential for appreciation (and risk of loss) and the biggest absolute distributions over time. The Growth & Distribution Fund will be in the middle, while Distribution Focus will provide the biggest initial payments but the least chance of growth with its conservative, fixed-income-heavy portfolio. To help figure out what kind of payment you'd get for a given investment, or vice versa, Vanguard has posted a calculator on its Web site.

Up Front Costs
Investors will need $25,000 to make an initial investment and $100 to add to their accounts. The funds' expense ratios will be about 0.58%, but that figure includes the market-neutral fund's "short-sale dividend expenses," which the fund covers by putting the proceeds of its short sales in interest-bearing accounts. Without the dividend expenses, the funds' expense ratios would be 0.27% to 0.28%.

Known Unknowns
These funds could be the most complex in Vanguard's lineup, which is why it's frustrating that the family has been so quiet on who will be involved in running them and how they will do it. To date, Vanguard has said CIO Gus Sauter will lead the investment committee and veteran index- and quant-fund manager Michael H. Buek will implement the committee's recommendations. But Vanguard hasn't said who will be on the committee besides Sauter nor described in detail the funds' investment strategies and processes other than to say they will rely on both quantitative models and qualitative research. Furthermore, Vanguard, though it has actively managed traditional funds like  Vanguard Strategic Equity (VSEQX) for years, has no public track record of running endowmentlike asset-allocation funds. That makes it hard to evaluate the payout funds at this stage, so I'd let them build a track record before making them a part of my portfolio.

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