Did Vanguard Goof on This Fund Launch?

Vanguard was one of many firms since 2007 to launch funds designed to turn investors' nest eggs into retirement income. Vanguard's were among the more interesting because they aspired to be mini-endowments. So far, they've been unimpressive.

Yet the funds, which Vanguard rolled out in May 2008, are still intriguing. They're designed to invest shareholders' money so that it generates enough income to support monthly payments and enough capital appreciation to perpetuate an investor's principal. By making allocations to domestic and foreign stocks, bonds, REITs, Treasury Inflation-Protected Securities, alternative strategies, and commodities, they aim to protect retirees against the risk of exhausting their savings before death, even as they tap it for spending.

So, far, though, they've merely served to point out the benefits of annuities that have guaranteed payouts. In the trailing year ended May 2009, roughly the funds' life span, they have shed between 22% and 28% and have been among the worst in the retirement-income category that includes about two dozen other monthly payout funds. A larger-than-average helping of stocks hurt, as did a helping of tanking commodities.

Because of the funds' losses, return of capital made up all of the funds' 2008 distributions. That means the funds essentially gave investors their money back. The poor performance also forced the funds' 2009 payout rates, which are determined by the portfolios' prior three years of performance, to drop by between 16% and 18% from last year. These funds can't go on losing money and returning capital to investors if they hope to achieve their objectives. Even if they do endure, investors who haven't added to their positions or reinvested their distributions face the prospect of smaller future payouts because they have less capital in the funds to compound over time.

It is tempting to say that Vanguard, which runs money for endowments but has no public track record managing mutual funds in this manner, is in over its head. The funds deserve more time, though. Their strategy and investment policy committee that makes the asset-allocation calls remain opaque. Vanguard also could add some complex features to the funds in the future, such as a yet-to-be-launched, Vanguard-run absolute return fund that tries to replicate the risk/reward characteristics of hedge funds. Nevertheless, the funds' design may prove to be more robust than it seems now. Adjusting their per-share payments based on the previous three years of performance takes some pressure off in rough times. When markets and performance improve, that same mechanism will ensure the payouts will increase. Those relatively heavy equity stakes that have looked so imprudent in the bear market also will be a boon in a recovery. Indeed, since the stock market bounced off the mat in March, all three payout funds have improved. Better results also mean that investors will eventually get more than their own capital back in their distributions, though, as of April, return of capital still made up 60% to 80% of the funds' payouts.

The funds' tactical moves also have been consistent with a long-term strategy. For example, in the fourth quarter of 2008, when the difference between yields on investment-grade corporate bonds and U.S. Treasury securities of comparable duration reached historic levels, the funds added  Vanguard Intermediate-Term Investment-Grade (VFICX) to their bond allocations. Similarly, when deflation fears drove down TIPS, two of the funds--Distribution Focus and Growth & Distribution Focus--added  Vanguard Inflation-Protected Securities (VIPSX). These should prove to be sound long-term investments.

Vanguard's payout funds' real-life stress test has reinforced what we already knew: They aren't guaranteed; they can return capital to shareholders; their monthly payout amounts can change; and they each have big equity stakes. So, investors have to put up with not only the possibility of short-term volatility but also variable income streams.

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