A version of this article appeared in the April 2014 issue of Morningstar FundInvestor.
After saving and investing for decades, retirees face a whole new realm of options when constructing a portfolio for use throughout their golden years. Morningstar's Retirement Income category contains several flavors of mutual funds worth consideration. Still, unlike an annuity, these funds do not offer any kind of guarantee and investors should be comfortable with the risks inherent in each strategy.
Target-Date Retirement Funds Retirement-income funds are often the final landing point of a target-date series' glide path. These are distinct vehicles that merge with the final dated fund in the series, either at retirement or--as in the case where the final dated fund continues to roll down the equity allocation--after a pre-specified number of years. Not all series have a separate retirement-income fund, though. For example, AllianceBernstein continues to offer 2000 and 2005 dated funds, which stay in the Morningstar Target Date 2000-2020 category.
Similarly to conservative-allocation funds, target-date retirement funds do not have an explicit income goal and are designed to provide broad exposure across asset classes, allowing for income as well as appreciation. These funds have an average trailing 12-month yield of 1.8%, which is below the 2.1% of the larger retirement-income category norm. On average, target-date retirement funds have a 28% allocation to stocks, although there is a wide range of allocations within this subset. For example,
American Century One Choice In Retirement holds a relatively aggressive 44% allocation in stocks, while Wells Fargo Advantage DJ Target Today has just 20% invested in stocks. Target-date investors should note the final equity allocation in their series', as it can dramatically affect the performance of their investment throughout retirement.
Income-Replacement Funds Perhaps best described as a reverse target-date fund, an income-replacement fund will gradually return your money plus any income and capital gains before it liquidates in a designated year. Fidelity offers 14 such funds at two-year intervals that invest in a broad array of Fidelity funds. PIMCO offers two options, one maturing in 2019 and one in 2029, which invest almost entirely in Treasury Inflation-Protected Securities. While PIMCO Real Income 2019 delivered a category-topping 12-month yield of 16.52% and PIMCO Real Income 2029 offered a 6.11% yield as of February 2014, they also suffered a 3% and 7% loss, respectively, during the trailing 12-month period as TIPS suffered from a recent sell-off.
Managed Payout Funds Managed payout funds provide monthly income with room for investment growth. When the market slows or drops, however, the fund can cut its payout or return your capital. The 12-month yield of each fund provides an idea of just how much income these funds have doled out. For example, Schwab offers three managed payout options, with distribution targets ranging between 3% and 6% annually. The series has had a tough time hitting those payout hurdles given the low-interest-rate environment of recent years, and the three funds have a 12-month yield ranging between 1.91% and 2.01%.
In contrast,
Vanguard Managed Payout has maintained a relatively aggressive profile and its hefty exposure to stocks (54% as of the end of 2013) along with a surging equity market in recent years has helped it maintain a payout level close to its target. (It has also had to return shareholder capital to retain its targeted payout rate at times.) The fund's trailing three-year performance determines its payout amount and the firm recently cut the fund's target distribution to 4% from 5% in January 2014, reflecting more modest return expectations for stocks and bonds. At that time the firm also consolidated its two other managed payout funds into this fund to create a single fund.
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