You'll have bills to pay for the rest of your life. Will your retirement nest egg last that long?
When you retire, you'll want two things from your retirement savings: regular income to cover your living expenses, and some assurance that your nest egg will last as long as you need it.
The financial industry offers a number of different investment products designed to help you handle the risk that you'll outlive your savings. Now, some new "managed payout" mutual funds from fund giants Vanguard and Fidelity offer a new spin on drawing down your nest egg. Although the funds have some useful features, they don't offer the guarantees that many retirees will want.
Percentage-based withdrawals made simple
The two fund companies take different approaches to solving the retirement income problem. Vanguard's managed payout funds combine a regular asset allocation strategy with systematic withdrawals based on the value of your portfolio. You can receive either 3%, 5%, or 7% of your portfolio's value each year, depending on which fund you choose.
Although the funds haven't started operating yet, the prospectus indicates that the funds can invest in several other Vanguard mutual funds. You'll definitely hold stock and bond funds. The prospectus also allows investments in less traditional vehicles, like market-neutral funds and commodities futures contracts.
The primary risk with these funds is that there's no guarantee they'll earn a high enough return to cover withdrawals. Although you'll never run out of money if you don't dip into your principal, your income may shrink to the point where it's not enough to cover your expenses, especially if your fund has a high payment rate. If it turns out that a bear market comes right after you retire, you may see a big drop in your monthly payments.
Pick a date
Fidelity's funds, on the other hand, are geared toward providing income for a fixed period of time. Currently, there are 14 different funds, with target dates between 2016 and 2042. Each fund invests in a mix of other Fidelity mutual funds that invest in stocks and bonds. Fund managers design the investment portfolio to support regular monthly withdrawals that will ideally keep up with inflation throughout the life of the fund. Rather than paying a fixed percentage of assets each year, the fund pays a different amount that depends on the number of years remaining until the fund's target date. At that time, the fund will distribute any remaining assets, and investors will receive no more payments.
Because these funds have been operating for several months, you can see what they invest in. For instance, the 2040 income replacement fund has about a 65%/35% allocation among various Fidelity stock and bond funds. Stock holdings of those funds include U.S. large caps like Cisco Systems
With the Fidelity funds, investors face slightly different risks. Because the fund automatically adjusts the percentage payouts upward over time, the odds are better that payments will keep up with inflation.
However, you have to guess which fund to pick. Because the funds are specifically designed to run out of money on your fund's target date, you'll have nothing left if you live longer than that.
Handling longevity risk
Because of these risks, managed payout funds can't replace immediate annuities, which guarantee payments that rise with inflation for as long as you live. However, the lower costs of funds and their asset-allocation approach to investing make them attractive to many retirees.
Using managed payout funds for convenience makes a lot of sense, as long as you don't commit all your money to them. By setting aside some of your money in other investments, you'll have a safety net if these funds don't last as long as you do.
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Fool contributor Dan Caplinger hopes he won't need income from his retirement funds for a long time. He doesn't own shares of the companies discussed in this article. J2 Global is a Hidden Gems Pay Dirt recommendation. There's a good chance that none of us will outlive the Fool's disclosure policy.