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Funds Fighting Inflation

The following is adapted from the December 2006 issue of Motley Fool Rule Your Retirement.

Every year, mutual funds distribute money to their shareholders in one of three forms:

  1. Dividends (in the case of stock funds).
  2. Interest (from bond funds, though your fund company may call this a "dividend").
  3. Capital gains (which are generated when a fund manager sells an investment -- stocks or bonds -- for a profit).

If you're like most investors, you've chosen to reinvest those distributions during your working career, buying more shares of the fund. But once you retire, you need income. So one of the first steps you might want to take after you've kissed the boss goodbye is to direct your mutual fund providers to stop reinvesting distributions and instead have them transferred to your money-market fund or checking account -- or opt to have them just send you a check in the mail. (In some cases, it makes sense to continue reinvesting distributions in retirement, but that's another article.)

Income gone wild
OK, you can count on your mutual funds to provide some of your retirement income. But how consistent is that income? When it comes to bond funds, the determining factor is prevailing interest rates. For example, the yield on the Vanguard Short-Term Bond Index Fund (FUND: VBISX  ) was just 2.83% in October 2004. But thanks in part to the Federal Reserve's interest rate increases, the fund now yields 4.84%. A 46% jump in two years shows how variable bond fund income can be.

Vanguard Short-Term Bond Index (VBISX)

No. of Bond Holdings

704

Current Yield

4.84%

Expense Ratio

0.18%

10-Year Annualized Returns*

5.07%

*Before taxes. Data from Vanguard.

Given that stocks are more volatile than bonds, you might think that the distributions from stock funds are even less predictable. And you'd be partially right. It all depends on whether you look at income (i.e., dividend) distributions or capital-gains distributions.

If you look at the income/capital gains distributions from the Vanguard 500 (FUND: VFINX  ) fund since 1977, you'd see that capital-gains distributions are all over the place (and nonexistent since 1999), but income distributions are much more consistent. More important, they increase gradually over time. Of course, every stock fund will have its own distribution history, but since the Vanguard 500 has been around for 30 years and is one of the larger equity mutual funds, it makes for a good case study.

Vanguard 500 Index (VFINX)

No. of Stock Holdings

507

Current Yield

1.74%

Expense Ratio

0.18%

10-Year Annualized Returns*

8.4%

Largest Holdings by Net Assets

ExxonMobil (NYSE: XOM  )
General Electric (NYSE: GE  )
Citigroup (NYSE: C  )

*Before taxes. Data from Morningstar.

Inflation-beating income
One of the biggest risks for retirees is income lagging inflation. Having stocks in your portfolio is one way to increase the chances that you'll be able to maintain your current lifestyle. But it's not just the increasing (you hope) stock prices that help you continue to afford to pay your bills. It's also the income that a broad portfolio of stocks produces -- a portfolio that, despite occasional dips, has shown an ability to keep up with inflation over the long term.

The Vanguard 500 fund distributed $0.58 per share in 1977 and $2.14 per share in 2006. According to the inflation calculator at the website of the Bureau of Labor Statistics, something that cost $0.58 in 1977 would cost $1.98 in 2006. My point: Fund distributions have kept up with inflation -- and then some (especially when capital gains distributions are factored in).

Foolish conclusion
When you're saving for retirement, you understandably pay more attention to the value of your stock mutual funds than the actual distributions. But once you've retired, those distributions become your way of paying the bills. Looking at the Vanguard 500 fund, it's clear that the distributions fluctuate. But it's heartening to know that they aren't as volatile as the S&P 500 itself. So, during those times when the market is in the dumps (and those times will inevitably happen), you can still expect -- if history is any guide -- to receive gradually increasing checks in the mail.

If you're looking for some more retirement tips, you can take advantage of a free "Open House" to my Rule Your Retirement service. Through March 12, you can check it out free of charge -- including stock and fund recommendations, interviews, and our online seminar, "How to Plan the Perfect Retirement." Click here to join the Rule Your Retirement Open House.

Motley Fool Rule Your Retirement advisor Robert Brokamp does not own shares of any company mentioned in this article. The Fool has a disclosure policy.


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