Return to Sender: Vanguard Payout Funds Dip into Capital

The market is giving Vanguard's new Managed Payout Funds quite a hazing.

Since their inception in May through the end of July, each of the offerings, designed to invest like miniendowments, has lost between 6.2% and 7.8%. Perhaps more alarming to investors who were counting on these funds to provide a stream of payments throughout their retirement, return of capital, not investment gains from income or capital appreciation, has comprised most of the funds' monthly payments. Return of capital has made up between 63% and 77% of the funds' first four monthly distributions. This means that, so far, fund shareholders have, for the most part, just gotten their money back. That can impair investors' future payments because it leaves less of their money in the fund to benefit from future compounding of capital gains and income.

It is still very early days; I think that the funds remain intriguing and may prove themselves worthy tools in the future. But this is not an auspicious beginning. One wonders how long shareholders will put up with just getting their principal handed back to them and whether the funds, which have about $300 million in assets among them, will succeed in their stated goal: creating regular income without exhausting investors' capital.

Vanguard maintains that the Managed Payout Funds will weather the current storm and meet their objective over the long term. The family acknowledges, though, that if the markets do not recover this year, the funds will reduce their payments next year. This is according to plan because the funds' payments are determined by a formula based on the offerings' returns over the previous three years. The current estimated monthly payments, based on an investment of $25,000 in each of the funds, is $70 for Vanguard Managed Payout Growth Focus, $116 for Vanguard Managed Payout Growth and Distribution Focus, and $162 for Vanguard Managed Payout Distribution Focus.

I don't expect the fund's investment committee to make any drastic course corrections to forestall lower payments next year. The payout funds, which invest in other Vanguard stock and bond funds, as well as commodities, base their asset allocations on the committee's assessment of the long-term risk and reward profiles of the underlying asset classes. Right now, the Growth and Distribution fund, Vanguard's middle-of-the-road offering, has about a third of its assets each in domestic and foreign stocks, including nearly 7% in emerging markets, 15% in domestic bonds, nearly 10% in the  Vanguard Market Neutral Fund (VMNFX), 5% in  Vanguard Inflation-Protected Securities (VIPSX), and about 5% in commodities. The Growth Focus fund has less in bonds and more in equity, while the Distribution Focus fund leans the other, more conservative way.

The funds' asset mix obviously has hurt them in the short term. It doesn't strike me as an unreasonable long-term plan, though. Time will tell. The Payout funds' first four months do reinforce a few things that I've noted in the past and that Vanguard, to its credit, has made an effort to warn investors about. These funds are not guaranteed like annuities. They can lose money, and, when they do, it can affect the composition and size of the payments. Because of this, the Payout Funds are probably best used, if at all, as one part of a post-retirement investing strategy. Finally, these funds still need time to prove themselves.

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