Mutual funds rose in popularity during a time when the accumulation of wealth was the main focus of most investors. Now, however, as more investors end their work careers, there looms a demand for a product that replaces a salary. This is the exact opposite of what most mutual funds are set up to do and the vast majority of fund companies do not appear to be preparing for the change that is slowly happening. A few, however, have ventured into the waters of distribution-focused mutual funds.
Vanguard has three offerings in this space, Vanguard Managed Payout Growth Focus (VPGFX), Vanguard Managed Payout Growth and Distribution Focus (VPGDX), and Vanguard Managed Payout Distribution Focus (VPDFX). With a $25,000 minimum investment, these funds aren’t inexpensive to get into, but, with a focus on distributions, it is understandable that such a high initial investment is needed. The funds pay a monthly distribution that is determined at the beginning of each year as a percentage of assets. Each fund has its own percentage based on the overall objective (growth, growth and income, or income), with a handy calculator at Vanguard’s website that will allow you to see what each fund will pay based on how much money an investor has in the fund.
It is important to note that the payout is set once for the entire year and does not change based on market conditions. The funds are “funds of funds”, each holding a basket of other Vanguard funds. The basic premise is similar to that of a typical endowment that takes a set percentage of assets each year to “give away” while allowing the rest of the assets in the endowment to continue to grow and, hopefully, support the ongoing payment.
Another fund that uses a similar “endowment” approach is Baron Retirement Income Fund (BRIFX). Only this fund distributes a set 4% of assets once annually (management has stated that there is a chance the fund will distribute a monthly dividend at some point, but it does not currently do so). This particular fund has a much lower $2,000 minimum investment and is, basically, a collection of the Baron Fund Family’s best ideas. Although Baron is best known as a small cap growth shop, it has expanded its offerings in recent years to include large cap and international options.
Interestingly, 4% of assets is the “rule of thumb” that many use as a sustainable distribution rate—in other words, it is believed that you can take 4% of assets from a portfolio without fully depleting the assets in the portfolio over a long period of time. Of course the period of time in question is a big determinant of the validity of the 4% rule. Note that the Vanguard funds, based on their objective, distribute different percentages. Although Vanguard doesn’t make the actual percentages readily available, they appear, based on the calculator provided at Vanguard’s website, to be between 3% and 7% of assets.
Although the sustainability of the 4% rule of thumb isn’t a certainty, it is a definite fact that the more money you take out of an account the more you increase the chances of running out of money. Therefore the higher distribution funds in Vanguard’s lineup have risk factors beyond just the stocks and bonds in the fund. It is also important to remember that the percentage of assets approach that all of these funds use means that the amount paid out in any one year will vary based on the performance of the underlying portfolio.
Fidelity has taken a vastly different approach from either of these fund families, as its offerings are intended to leave an investor with nothing at the end of a set period of time, or target date. The funds are called Fidelity Income Replacement Funds, with a target date specified for each fund. The target dates currently go in two-year increments out to the 2040s. This is a vastly different approach, as you are basically attempting to predict the day you will no longer need to receive money from this investment. Some might call this target date a terminal date—as the day you die could be argued as the last day you will need money. Like the Vanguard offerings, these funds have a minimum initial investment of $25,000 and are “funds of funds,” owning a diversified collection of Fidelity funds.
Load fund families Pimco and John Hancock also have offerings in this space. The offerings from these families are similar, but slightly more complex. Generally, they are also offered by someone receiving a commission for their sale—which some believe can create a conflict of interest.
It will be interesting to see if the “endowment” or “depletion” approach catches on, as they are so different. Of course, an individual could set up a similar distribution plan without owning these types of funds, but that would require more diligence on the part of the shareholder, a level of effort that may be undesirable in early retirement and, for some, too much to handle in later years. So the ease of a single step solution to the distribution issue is one that is likely to catch on over the coming years.