Morningstar Advisor - Spring 2008 - 45

Mutual Funds Take a Swing at Retirement Income Fund Lineup Name Number of funds Load (%) Minimum Investment ($) Expense Ratio (%) Payment Schedule Strategy Fidelity Income Replacement Vanguard Managed Payout Russell Retirement Distribution Schwab Monthly Income John Hancock Retirement Income DWS LifeCompass Income 14 3 3 3 1 1 5.75* None 5.75 None 5% 5.75 25,000 25,000 initial; 100 additional None 100 1,000 1,000 0.54–1.66 0.27–0.28 1.24–1.33 0.61–0.76 1.35 1.87 Monthly Monthly Annual Monthly Quarterly Semiannual Pay dividend, while gradually returning principal and any earnings, through liquidation year. No liquidation. Pay dividend as a percentage of assets while achieving some capital growth. Pay dividend through liquidation year. Return principal and any unpaid capital gains in liquidation year. No liquidation. Pay dividend as a percentage of assets while achieving some capital growth. No liquidation. Pay dividend as a percentage of assets while achieving some capital growth. Pay dividend through liquidation year, returning principal and any unpaid capital gains on liquidation date. Payments insured, with conditions. *Advisor shares Potential Uses Red Flags Officially Intriguing So, how do you use these things? Most of the funds’ filings caution that they are not one-stop options for retirement income. Indeed, these vehicles are too unproven to entrust them with a client’s entire nest egg. Advisors should regard them as supplementary income sources. A client, for example, could keep a portion of his portfolio in a conventional array of stocks, bonds, and cash; set up an inflationadjusted immediate annuity to cover essential expenses; and then use a distribution fund for expenses that aren’t essential, such as travel and hobbies. The client could more easily curtail such discretionary expenses than spending on food, clothing, shelter, and health care if his distribution funds fail. Early retirees also could use distribution funds as a bridge to Social Security. If a client retires at age 55, for example, a distribution fund could provide her supplemental income until Social Security kicks in 10 years later. Of course, the funds have to work as advertised for them to be of use. We don’t have much distribution history to judge if Fidelity’s funds are effective. Vanguard runs $17 billion for endowment and foundations, but it doesn’t have a visible track record of doing this kind of investing for retail shareholders. The other funds highlighted are just as unproven, and in the case of Russell, John Hancock, and DWS, much more expensive. These funds also won’t be tax-efficient. In addition to bond income and capital gains, for example, Vanguard’s distributions could include both short- and long-term gains from futures contracts used for commodities exposure. The funds also won’t automatically satisfy the required minimum distributions investors must take from their IRAs once they reach 70 1/2. That’s still a function of an investor’s age, account value, and the distribution period determined by the IRS. So they are not going to put tax and financial advisors out of business. These strategies are novel and new, so we’ll reserve judgment on them until they build track records. They are intriguing, though, particularly the funds that aim to invest like miniature endowments. And they’re probably not the last word on the retirement puzzle, either. Just as fund companies’ first attempts at a one-stop portfolio, such as Vanguard STAR VGSTX, begat more-sophisticated asset-allocation funds of funds and target-retirement lineups, income-distribution funds may be just the first of many ideas for helping investors live off their investments. Time will tell if these new funds prove useful and successful, but at least fund companies are thinking about developing solutions rather than merely rolling out more trendy funds. K Daniel Culloton is a senior mutual fund analyst with Morningstar and editor of Morningstar’s Vanguard Fund Family Report. Andrew Gunter is a mutual fund analyst with Morningstar. MorningstarAdvisor.com 45

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Morningstar Advisor - Spring 2008

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