Vanguard Managed Payout Funds Face Up to Challenges

Last week's announcement that Vanguard was "simplifying" its lineup by merging a number of mutual funds may have obscured the fact that, as fund companies have done since time immemorial, Vanguard is also attempting to paper over a few of its mistakes. For instance, unrated Vanguard Growth Equity , a subadvised offering that ranks in the bottom quintile of the large-growth category over the past 10 years, has never really found its footing. It's being merged into another subadvised strategy,  Vanguard U.S. Growth (VWUSX).

"Mistake" is too strong a word to describe the fate of Vanguard's Bronze-rated Managed Payout Funds, which are being merged from three distinct strategies into one. But certainly "success" is not an apt description either. Launched in 2008, the funds attempt to use a total-return strategy to generate a relatively dependable distribution stream for retirees as part of their retirement-income portfolios, each with a different level of targeted payout. By Vanguard's standards, the funds have remained tiny. Under the merger plan, the largest and smallest funds--the $800 million  Distribution Focus Fund and the $110 million  Growth Focus Fund --will merge into the $531 million  Growth and Distribution Fund , which also has the most moderate asset allocation and distribution target of the three. As part of the change, the remaining fund will be renamed Vanguard Managed Payout, and its target distribution rate will be lowered to 4% from 5%, which Vanguard believes will be a more attainable long-term goal that matches a reasonable drawdown rate for most retirees.

Vanguard has hardly been alone in its struggles to gain traction for managed-payout funds. Both Fidelity and Schwab launched managed-payout strategies around the same time as Vanguard, in late 2007 and early 2008 (although they all use different investment designs and payout methodologies), respectively. As of Sept. 30, 2013, Schwab had less than $200 million in assets in its Monthly Income Funds and Fidelity less than $100 million across its Income Replacement offerings; so by comparison, Vanguard's funds have been a raging success. Other firms, such as Russell, introduced monthly payout products that they later liquidated or merged away.

From an investment perspective, one problem has been timing. Launched in the midst of one of the worst bear markets on record, the Vanguard funds' equity-heavy approach was handicapped out of the gate. The low-interest-rate environment has been a further impediment. The funds have had limited opportunity to draw on income to support their distributions, creating more pressure on the equitylike sleeve to generate capital gains.

An equal if not greater trouble spot has been communicating the funds' story to investors, as Vanguard acknowledged in its press release. A recent survey by Cerulli Associates found that simplicity was the single factor deemed most important in the success of a retirement-income product. But the Vanguard Managed Payout Funds have been bedeviled by their complexity. The payout formula (based on average hypothetical account value over the previous three years) is not easy to understand, and the resulting variable payout rates perhaps have created a mismatch with investors' perception that the stated payout percentage referred to a stable income rate. In addition, Vanguard's "mini-endowment" approach to constructing the funds--incorporating commodities, REITs, and market-neutral strategies alongside stocks and bonds--may be common in the pension world but is not familiar to most retail investors.

The funds certainly have not suffered from a lack of investor appetite for income-producing investment products. As shown in the huge recent flows into multiasset income-oriented vehicles such as  JPMorgan Income Builder (JNBAX),  BlackRock Multi-Asset Income (BAICX), and  Franklin Income (FKINX), not to mention the growth of dividend-focused equity strategies, investors appear to have an unquenchable thirst for such strategies.

The Vanguard Managed Payout Funds don't have the flash of these other income-oriented funds. Generating income isn't even their primary modus operandi. The mini-endowment approach requires a more patient, long-term perspective and a more subtle understanding of strategy, both of which are often tough sells in today's environment. Will Vanguard's merger be the move that helps save these strategies or is it just a last-ditch effort to hold off their demise? It's hard to say, but there does seem to be a place for a low-cost, total-return approach to income as one slice within a retiree's larger investment portfolio. Lowering the target payout rate to 4% may be disappointing to investors, particularly those who previously had Distribution Focus' 7% rate, but it does seem to give the fund a viable chance of meeting its goals. Whether investors will stick around to participate remains to be seen, but for now Vanguard appears committed to keeping the managed-payout concept alive.