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Once upon a time, retirees didn't have to worry about setting up a stream of income to live on—they received pension checks month in and month out.
Today, most workers are in charge of not only saving for retirement but also converting their savings into income streams they won't outlive. Their typical choices: manage their investments and withdrawals themselves, hire an adviser to do so, or buy annuities with income guarantees.
In recent years, though, mutual fund companies have thrown another solution into the mix: target-income funds.
"As the onus has gone onto retirement plan participants to wring income out of their investment assets, (fund companies) have seen that there's definitely an opening to help," says Christine Benz, director of personal finance at Morningstar.
Target-income funds, also known as income-replacement funds or managed-payout funds, started appearing about five years ago. While their designs vary, these funds—which had $1.36 billion of assets as of June—have a common goal: investing your assets with an eye toward providing you income over a specific period of time.
Target-income funds shouldn't be confused with the older and better-known "target-date funds," which are aimed at investors who are growing nest eggs. The newer counterparts, on the other hand, were created for those who need to convert their savings into income streams similar to those pensions used to provide. There are two main types of target-income funds.
The first runs through a certain date, say 2016 or 2042. The longer-horizon funds can provide income through what you project to be your life expectancy. The shorter-horizon ones can be used to plug income gaps, for instance between the time you retire and the time you start drawing Social Security benefits.
The second is designed to provide investors with payments until their death, whenever that may occur. Because these so-called perpetuity funds are designed to preserve principal as long as possible, their payouts as a percentage of assets are typically smaller. Both versions of the funds rebalance to become more conservative as their target dates near.
Target-income funds have much to recommend them. But as with any investment, it's important to do research before handing over your assets, says Benz: "The onus is on investors to do the homework and make sure they understand what they're getting."
There's no single formula for how fund companies build target-income funds. Fidelity and a number of other fund firms use a "multi-asset approach," explains Benz, meaning the funds include both stocks and bonds, with the aim of growing your investments along with generating a predictable stream of income.
This approach makes sense because "most retirees' plans will involve tapping their capital," explains Benz. The logic: The more you grow the investment capital in the fund, the more you'll have available to dip into.
Others fund firms, such as PIMCO, focus on current income above all. PIMCO's Real Income Funds invest primarily in Treasury Inflation Protected Securities, or TIPS, notes Benz. TIPS are Treasury securities that are indexed to inflation to produce more income as inflation rises.
This approach has its merits as well, says Benz. "It acknowledges that protecting retirees' purchasing power is a key part of the challenge," she says.
Which sort of fund is best for you? That depends, says Benz. Some investors may want to put part of their savings in funds that are purely focused on current income in order to guard against inflation. This gives them more control over how they invest the rest of their assets.
Indeed, that's how PIMCO's target-income funds are often used, says Michael Cogswell, a senior vice president at the firm. "They're a great tool because they keep up with inflation," he says. "We'd expect that they complement Social Security, IRAs" and other retirement investments.
But if retirees want the simplicity of a single solution for all their assets, a more diversified fund may be the way to go, says Benz.
One of the central attractions of target-income funds is that they free retirees from playing investment manager. While do-it-yourself investing may seem simple in strong markets, it can be a gut check in down or volatile markets, and studies show that most average investors are especially prone to making poor decisions under stressful conditions. With target-income funds, you'll know a disciplined professional is at the helm.
Another big advantage of target-income funds: their liquidity. If you have an emergency and need your principal back, it will be returned to you at no charge.
"Five years from now if you change your mind, or if your circumstances change, you're not locked in," says Joe Cullen, head of institutional portfolio management at Fidelity Investments.
Annuities – a popular alternative for people seeking to convert savings into a predictable income stream – are typically non-refundable. With the most common "immediate annuities," you pay a lump sum to an insurance company and start receiving regular income payments right away.
Target-income funds may also prove to be a good choice should your lifespan get cut short. In the event of early death, target-income funds distribute your remaining assets to your beneficiaries. With annuities, not so much: Their lifetime-income guarantees mean that you won't outlive your income, but if you die six months after investing, say, $200,000, the insurance company keeps the money and your heirs are out of luck.
Now for the drawbacks of target-income funds. First, as with any non-guaranteed investment, there's no assurance you'll get your principal back. Indeed, a market collapse could decimate your assets. But that's true for most investments.
A more realistic concern may be that the size of your monthly check can vary. In order to make your money last, target-income funds typically make lower payments when markets are down.
"This may not sit well with some retirees who depend upon steady income," says Kevin Worthley, a financial planner in Warwick, R.I.
The good news is that you can expect larger monthly checks when markets are rising.
Second, target-income funds are not customizable. Let's say you have a relatively high tolerance for risk—perhaps because you have a second source of income. If you invest in a 2025 fund, say, your fellow investors could be retirees living by the skin of their teeth who are terrified of risk. Worthley refers to the problem as a "one-size-fits-all asset allocation."
"In general, these funds may not account for a retiree's market-risk tolerance," he explains.
There's a way around that dilemma if you're willing to do a bit more legwork, says Fidelity's Cullen. Funds with a shorter horizon are invested more conservatively, while those with a longer horizon are typically invested more aggressively.
Thus, investors can buy a longer-horizon fund, hold it for a few years, and then swap their assets into another aggressive fund as the original fund pivots to a more conservative makeup.
Likewise, investors who want a long-term investment—but want lower risk throughout the fund's entire lifespan—can invest in a fund with a near-horizon, invest in a similar one at maturity, and so on.
That level of involvement may not be palatable for some investors, Cullen notes. "In most cases, that type of process requires a lot more intervention and discipline of an individual to think about it and do it," he says.
Finally, target-income funds are still relatively new. It will take a track record of many years to fully evaluate their effectiveness, advisers say.
"These are relatively new financial products and have not had much time to season," says Worthley.
Still, for investors concerned with converting savings to income, these funds are worth a look, investment advisers say.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.