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The holy grail of retirement income is guaranteed, inflation-adjusted payments that last a lifetime, with principal left over. Annuities offer that kind of lifetime income, at the cost of giving up your principal. But true inflation-adjusted annuities are hard to find, and very expensive.

On the other hand, investment portfolios with a sizable allocation to stocks have typically kept up with inflation, and can potentially produce lifetime income, with principal left over. But a portfolio’s actual longevity, and the size of payments it can support, are governed by the statistics of future market returns and are never guaranteed.

Is there a hybrid solution that can give you some of the lifetime income of an annuity, while offering the inflation protection and principal availability of an investment portfolio? In this post, I look at “managed-payout funds” and related investment products that attempt to provide retirement income without an annuity contract and could, potentially, generate much of your cash flow in retirement….

To start, I’ll dig into related investment products from Fidelity, Schwab, Vanguard, and Dimensional Fund Advisors (DFA). This isn’t an exhaustive list. A few other companies offer similar products. But the discussion below covers many of the available offerings and should be representative of what you can find from other major players:

Fidelity

Fidelity, one of the first to offer a managed-payout fund, has recently renamed their offering from the “Income Replacement Funds” to the “Simplicity RMD funds”.

These funds are targeted at older retirees, approaching age 70-½ or older, who want to withdraw the value of their account over time in required minimum distributions (RMDs) as required by the IRS. They feature target dates, currently 2005 (FIRPX), 2010 (FIRRX), 2015 (FIRUX), and 2020 (FIRWX), which would be the approximate date when you turn, or turned, 70.

Fidelity’s funds are designed to become more conservative, with a smaller allocation to equities over time. Eventually they all reach an allocation similar to the Simplicity RMD Income Fund (FIRNX: currently 26% stocks, 53% bonds, 21% cash), and ultimately merge with it. Expense ratios currently range from 0.47% to 0.62%.

Each of the funds is comprised of a dizzying array of 25+ underlying Fidelity funds, many of which are actively managed. You would need to have some confidence in Fidelity’s approach to active investment management to feel comfortable in one of their RMD funds.

Fidelity apparently doesn’t target any level of income from these funds until their target date is reached. Rather, their distinguishing feature is the option to automatically calculate and distribute your RMD from the fund once you’ve reached 70-½. (Using the government’s RMD tables as a withdrawal strategy is a conservative plan that portions out your assets according to your life expectancy.)

Surely this is a useful service for those in their 70’s, but it’s a bit of a head scratcher as the distinguishing feature for a mutual fund. Most major fund companies offer the ability to compute and distribute RMDs, at the account level if not the fund level. And Fidelity’s mechanism is unlikely to be a complete solution for retirement income unless it’s integrated somehow with all your other retirement investments.

Schwab

Schwab’s offering in the managed-payout space is its family of Monthly Income Funds, available in Moderate (SWJRX), Enhanced (SWKRX), and Maximum (SWLRX) Payout versions.

Each of the Schwab funds targets a certain payout percentage, depending on the interest rate environment. With low interest rates, like now, the targets are 3% or less for the Moderate Payout fund, 4% or less for the Enhanced Payout Fund, and 5% or less for the Maximum Payout fund. With high interest rates, the targets are 6%, 7%, and 8% respectively. But these payouts can vary broadly, by 2-4% depending on the fund and interest rates. That could be a 50-100% variation in your actual payments received! So there are no guarantees about the actual cash flow you will receive with these funds.

Like Fidelity, Schwab employs a fund-of-funds strategy. Their Monthly Income Funds are composed of a handful of other Schwab and Laudus index and actively managed funds. Each fund has a target equity allocation range. But those ranges can vary from 25% to 40%. And those are very broad targets, so regardless of any underlying index funds being used, this is active management for the purpose of optimizing your retirement income.

Expense ratios currently range from 0.46% to 0.65%.

Vanguard

Vanguard recently consolidated all of its managed payout offerings into its single Managed Payout Fund (VPGDX), which targets a 4% withdrawal rate for your lifetime. This, however, is not the “4% Rule”. That Rule would provide a fixed withdrawal, adjusted by inflation each year.

Rather, Vanguard’s fund pays out a dynamic amount, computed as a percentage of your portfolio’s value each year. Vanguard recomputes the dollar amount of the scheduled monthly distribution each January, based on the Fund’s performance over the past three years. The three-year look back “smooths” out your income, helping to avoid sharp increases or decreases in your retirement cash flow.

(Research has demonstrated the utility of Vanguard’s withdrawal algorithm: According to Joe Tomlinson “The Vanguard approach shows significant improvement over the base case in terms of income produced, risk measures and bequests.”)

As with most of the other managed-payout funds, Vanguard’s is actively managed. First, some of the underlying funds are actually active funds, whose managers are striving to outperform a benchmark. Second, the Managed Payout Fund’s managers will adjust the fund’s overall asset allocation in an attempt to sustain its committed monthly payments, keep pace with inflation, and preserve capital.

Looking further into Vanguard’s fund, there are some exotic holdings like Alternative Strategies, Minimum Volatility, and Market Neutral funds. I’m not familiar with how those funds work, but I can say from reading the summaries that they are complex. How will they behave over the long haul, or when the going gets rough? Obviously Vanguard believes this is a mix that can support a 4% withdrawal rate, but nobody can prove that.

The current expense ratio is 0.34%. Since many of Vanguard’s large index funds offer expense ratios approximately one-third of that, this is like paying an advisor a tenth of a percent or two annually to manage your investments for retirement income. That’s a job that an experienced investor could do for themselves. But it’s pretty cheap for somebody who doesn’t have the experience and wants the peace of mind of paying for expert advice.

Dimensional Fund Advisors

Finally, though it’s not exactly a managed-payout fund, let’s touch on DFA’s Target Date Retirement Income Funds, because they are designed with particular attention to the income phase of retirement.

I have seen these funds described as “lifecycle based” or as using a “liability matching strategy.” Those appear to be fancy words to say that DFA is focused on preserving your spending power down the road in retirement, rather than on simply providing a certain nominal income or return.

In the words of Wade Pfau, this means that “rather than transitioning from stocks into duration-mismatched nominal bonds as the target date approaches, DFA’s funds transition into a portfolio of TIPS [Treasury Inflation-Protected Securities] with the same duration as a twenty-five-year real [inflation-adjusted] spending objective beginning at the target date.”

According to Pfau, DFA’s offering is an effort to provide investors with a defined-benefit or pension-like income, from their defined-contribution (401k/IRA) account, via a mutual fund.

DFA has an extensive lineup of these funds with target dates up to 2060, plus an associated Retirement Income Fund (TDIFX). Net expense ratios are relatively competitive, ranging from 0.21% to 0.29%. (But note that DFA funds are generally only available through licensed financial advisors, and you may be required to pay that advisor’s fees to access the funds.)

Managed-Payout Pros

So we’ve reviewed the specifications of managed-payout offerings from several of the big players. But, is a managed-payout fund right for you? Let’s review the pros and cons, starting with the positives:

The primary benefit of managed-payout funds is their simplicity for generating retirement income. Once you choose a fund and designate a deposit account for distributions, you can sit back and collect your retirement income without further thought. Little knowledge or discipline is required on your part: just spend the payments you receive. As long as you don’t dip into your principal by selling shares, you can be confident that an experienced investment team is doing the math on your behalf, and trying to generate a stable retirement income stream for your remaining decades. (What you can’t be certain about is whether, or how well, they will succeed. Your payments will surely fluctuate, at least in nominal terms, and perhaps in inflation-adjusted terms as well.)

The second significant benefit of a managed-payout fund is that you retain control of your principle. Unlike an annuity, where your principal is generally consumed at some point to finance other long-lived participants, with a managed-payout fund you can withdraw some or all of your principal at any time. If you have an emergency, or a change in plans or finances, this provides significant peace of mind. Just understand that flexibility always has a cost: In this case it will reduce the size of your payments, compared to an annuity, because there are no “mortality credits” from other annuitants to fall back on, should you be the longer-lived one.

Managed-Payout Cons

Unfortunately, managed-payout funds, like virtually all retirement income solutions, have significant shortcomings:

For starters, the underlying basis of these funds is an investment portfolio whose principal you can withdraw at any time. That means there can never be any guarantees on the size or longevity of payments. Ideally, a seasoned investment manager will be doing their best to optimize your retirement income stream. But they will have to operate within the context of a fluctuating stock market that nobody can predict. And, because you are not giving up any of your principal to insurance premiums, there can be no insurance component to protect your payments in the event of a sustained downturn, or a very long life. Your payments will fluctuate. They could even become vanishingly small or end.

All of the funds discussed above employ active management, either in the underlying investment choices, or in the ongoing asset allocation. Some degree of active management might be necessary to customize real-world investment performance to support a stable income stream. However, there is very little evidence that active management can outperform the market, and it typically underperforms. The statistics tell us that if your sole goal is to maximize income, without regard to volatility, you’d probably be best off putting all your money in index funds and taking a total return approach when you make your withdrawals.

The details of how these managed payout funds work are hard to obtain from the boilerplate of the financial company prospectus. But it seems likely that the average do-it-yourselfer could perform the job themselves and save management costs. Assuming you pay 0.3% more in fees for a managed payout fund, on a $500,000 retirement asset that would be $1,500 annually in expenses. However a reasonably savvy investor can implement their own retirement glide path by changing their stock allocation over time. And they can do some simple math to compute a safe monthly income, and then set up an automatic monthly withdrawal on their accounts — a mechanism every modern financial company supports.

Then there is one last limitation on how far a managed-payout fund can go to simplify your financial life in retirement. Because, unless you put all of your money in a single investment fund — potentially a risky proposition — you, or an advisor you hire, will need to coordinate the payouts with the balance of your portfolio. It won’t be one-stop shopping, unless you maintain no other assets!

Your Decision

The entire concept of managed-payout funds is relatively new and unproven, having been introduced only in the last decade. And they have yet to demonstrate much popular or commercial success. According to an analyst at Morningstar, managed-payout funds have less than $5 billion in assets, compared to roughly $900 billion in target-date funds. The renamings and consolidations mentioned in passing above are the financial industry’s response. Will the new offerings be more compelling?

When all is said and done these managed-payout funds are really just another framework for paying a financial advisor to manage your investments and dole out monthly income to you in retirement. They provide more structure and policy for that arrangement than some mechanisms, such as hiring an independent advisor, but less than others, such as buying an annuity.

Provided the expense ratio is reasonably low, there is nothing inherently wrong with the managed-payout approach. But because of the variables and future unknowns, deciding which among the managed-payout options is optimal, or how they compare to other retirement income solutions is difficult indeed.

By packaging a retirement income service within the context of a mutual fund, managed-payout funds might prove to be an effective solution for one part of your retirement income puzzle — but they are unlikely to be a cure-all.

I could see choosing a managed payout fund (probably Vanguard’s) for a modest portion of my retirement assets down the road, especially as I try to put our investments on autopilot for our later years. Until then, I think I can do as well managing my own investments and withdrawing retirement income on my own schedule. And I doubt I would ever commit more than about 25% of our assets to a managed-payout fund. I want more diversification in my retirement income sources.

According to Tomlinson, better results can be achieved with a combination of Single Premium Immediate Annuities (SPIAs) plus flexible withdrawals like managed payouts: “a SPIA and managed payouts is attractive on all measures,” he writes.

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Breaking News: I recently learned that Can I Retire Yet? has been selected as a finalist for Best Retirement Blog in the 8th Annual Plutus Awards. The annual Plutus Awards celebrate the best in financial media. This year marks the eighth annual event, and the ceremony will be presented live at the FinCon Expo in Dallas, Texas, on October 28. The Plutus Awards were founded by Harlan Landes and are supported by the Plutus Foundation. You can find out more at plutusawards.com and plutusfoundation.org.

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