The Fund Industry's Struggle to Provide Retirement Income

Temporarily Defeated Note: I had intended this column to continue my string of topical articles. The $2 trillion stimulus package and stock rally encouraged me to revisit last month's Treasurys article, which found the long bond's yield to be "unappealingly low" but not irrational. Could I write the latter with the government debt/gross domestic product ratio set to blow past 110% and equities seemingly anticipating healthy long-term growth?

No, I could not. I could only intone “asset inflation”--the thesis that aggressive money creation has pushed the prices of financial assets above their true values. However, I recoil from that answer. Belief in asset inflation suggests that the financial markets are fundamentally irrational, which contradicts both my training and most of my experiences. Also, the proposition looks to be untestable.

I will consider Treasury yields further. In the interim, something more evergreen.

The Starting Point Without assets, there is no need for a retirement-income strategy. Per the Government Accountability Office, half of Americans over the age of 55 have neither a 401(k) account nor an IRA. Some have sizable taxable accounts (more on that shortly), but for those who do not, planning retirement income is a straightforward task. Await the Social Security and (perhaps) pension checks.

For those who do hold financial assets, the simplest retirement-income strategy, with which I am very familiar, as it was the only tactic practiced by any branch of my family, is to hold cash. This wasn’t a bad approach back in the day; my grandfather sold his house when he retired, stashed $100,000 into a CD, and five years he owned $200,000. However, such accidents are no longer possible. (And how!)

Bond ladders would been wiser for my grandfather, because they reduce timing risk. He never encountered that problem, because he came into money when interest rates were sky-high, died when they were still relatively generous, and did not need the income to pay his bills. No such luck for my mother. When interest rates declined shortly after she retired, it cut sharply into her lifestyle, as she was attempting to live off that income while not touching her capital. She tapped into her stash, unhappily.

Mom would have been better off yet blending stocks with a bond ladder, thereby giving her portfolio a chance to keep pace with inflation. But at that point, things start to get complicated. How much to put into stocks, when to adapt to big market movements, when (if ever) to dip into equity capital? Also, what about annuities? They offer the highest yields, accompanied by a guarantee. They seem appropriate.

At this point, those who possess enough money hire good professional help (which is what Mom should have done). Those with fewer assets, though, will likely need to discover their own solutions, through fund companies.

Enter Mutual Funds I know what their answer is not: traditional mutual funds. Over the years, fund sponsors have marketed equity-income funds, income funds (similar, but with more bonds), balanced funds, and various flavors of asset-allocation funds, all of which possess the twin goals of providing current income while growing capital fast enough to keep apace with inflation. Such investments are fine, and they have their admirers, but they aren't particularly popular. The vast majority of industry assets are in funds that either buy only stocks or buy only bonds.

The problem with hybrid funds, as we used to call them, is twofold. First, they differ substantially. Some have double the yields of others, usually with correspondingly higher volatility, but also better growth prospects. It’s difficult for investors to find the appropriate choice. Second, they fluctuate with the stock market, albeit less markedly. Many retirees refuse to accept significant capital losses, because of the possibility that they will never get that money back.

Financial-services companies have been unable to fill the void.

Failed Solutions One approach is to use insurance. The most logical way to blend income, capital growth, and downside projection is through a structured note: a derivative security that can deliver those attributes more reliably than can either mutual funds or exchange-traded funds. Unfortunately, structured notes suffer from various drawbacks, including high cost, lack of transparency, and illiquidity, and therefore they have never gained significant traction in the United States.

Another angle, adopted by Vanguard, Schwab, and Fidelity, is to create managed payout funds. As with target-date funds, managed payout funds are registered funds under the Investment Company Act of 1940. Also echoing target-date funds, managed payout funds describe themselves not by asset class (such as “large-growth stock” or “government bond”) but instead by their goal. Hand them your retirement assets, and they will take control from there.

Sounds perfect--but wasn't. Such funds had the misfortune of debuting during the global financial crisis, which hurt both their early performance and marketing; they never did find their footing. Schwab's funds still exist in their original form, albeit with tiny asset bases, but first Fidelity and then Vanguard abandoned ship, by changing their funds' mandates. Managed payout funds still exist, but barely.

That leaves target-date retirement funds (sometimes called “retirement income”) as the remaining mutual fund hope. I think not. For one, they face the same problem as hybrid funds, in that their investment strategies vary substantially. Equity positions range from 15% to 40%. Also, target-date retirement funds are accidental investments: a place where shareholders eventually land, years after they purchased something else. Few investors actively buy such funds.

Something Different? That leaves the newest industry innovation, which is neither a fund, nor need it be operated by a fund company: digital advice, or more colloquially "robo-advice." In theory, digital advice avoids several existing problems. It requires affirmative action from investors, thereby eliciting commitment and understanding that target-date retirement funds lack, but it neither demands expertise nor saddles the shareholders with the disadvantages of structured notes. Also, the price tends to be right.

Despite extensive media coverage, though, takeup has been sluggish. Late last year, the consultant Aite Group estimated that digital advice commanded $280 billion, with most of that occurring within Vanguard and Schwab rather than pure digital-advice providers, and most of the Vanguard and Schwab assets having transferred within the firm rather than come from outside it. Ultimately, investors rather than providers will determine the retirement income solution for the masses. Their decision has yet to be made.

Market-Timers Anonymous Last month, to guard against a further stock-market decline, I had the bright idea of buying S&P 500 put options that will likely expire worthless. It turns out that the nation's largest pension fund, California Public Employees' Retirement System, made the same mistake, but in reverse. For 2.5 years, CalPERs used a "tail-risk hedging strategy" for (an admittedly small) portion of its portfolio. CalPERs unwound that hedge late last year, just before this winter's stock crash.

Great minds think alike! Or something.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.