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Investing January 31, 2008, 5:00PM EST

Retirement: Funds to Keep the Income Flowing

By Lauren Young

Boomers, prepare for the deluge. For years, fund companies have been focused on creating a product that would generate a steady stream of retirement income. Now, those products are here, and investors can expect to see a wave of offerings in a variety of styles.

Vanguard Group and Russell Investments both plan to launch income funds by the end of March, while T. Rowe Price (TROW) aims to introduce a group of funds by September. Fidelity Investments just added three new portfolios to the lineup it introduced last fall, and Charles Schwab (SCHW), Pimco, and others have similar products planned.

At their core, retirement income funds are portfolios of funds spread across asset classes. The new twist is that the split between asset classes is actively managed to produce a projected income stream. But instead of guaranteeing a fixed payout like an annuity or pension plan, the funds strive to provide annual income that ranges from 3% to more than 12%, depending on how they're constructed. The income payout plans, composition, and costs can vary dramatically.

That twist is creating some confusion about the way the funds work. "Even very intelligent clients of mine think that the return in these funds is guaranteed. It is not," says Debra Brede, president of D.K. Brede Investment Management, a wealth-management firm in Needham, Mass. Ernest Hathaway, a planner at investment advisory Financial Strategies Institute in Midvale, Utah, has a more fundamental worry: "My concern is that a steep market decline or a prolonged bear market will cause investors' incomes to drop significantly."

To get a sense of how Fidelity's funds work, look at Fidelity's 2016 Retirement Income Replacement Fund. If you invest $100,000 in it today, you'll get the annual income generated from the portfolio, currently targeted at 12.2% (the payment is made up of a dividend distribution and proceeds from the sale of shares each month). That payment aims to keep pace with inflation. By 2016, you will have used up your $100,000 investment. Notwithstanding the term "replacement fund," it's basically a withdrawal program with a little extra kick.

Vanguard's three funds, by contrast, aim to preserve your initial investment. Also, they have no expiration date. Retirement income funds do share common ground in the basic building blocks of their portfolios: investment-grade bonds, short-term bonds, high-yield bonds, domestic equity, and international equity. The mix can vary from company to company. For example, the Fidelity 2018 fund is 41.5% equities, 38.2% bonds, and 20.3% cash. The asset mix in a comparable 10-year Russell fund is currently 41% stocks, 59% bonds, and other short-term assets.

The fund manager's job is to tweak the portfolio to keep the desired income stream on target. But such moves may create a sizable tax bill. That's why Peter Rekstad, a financial adviser at TruNorth, a wealth-management firm in Oakdale, Minn., plans to use the Russell funds in Individual Retirement Accounts for his retired clients. For taxable accounts, "I'm going to need to see much more about the product to decide how to use them," he says.

PUZZLE PIECE

Retirement income funds are not designed to be an investor's sole source of income. "We envision them as one piece of the puzzle," says Boyce Greer, president of fixed-income and asset allocation at Fidelity. Greer suggests they be used to bridge the gap between early retirement and the period when Social Security kicks in, or to complement pensions and other income sources.

Investors are already using Fidelity's funds in surprising ways. One 89-year-old husband, who is terminally ill, invested in a retirement income fund to make sure his wife, who is 87, will have an easy way to get income upon his death, Greer says. Customers are buying the funds to pay for nursing home costs and as a replacement for trusts, which have costly administration fees. While the income funds may make sense for smaller sums, advisers say that for accounts of $500,000 and up, they can generate similar results.

It's too soon to judge retirement income funds based on returns. But they seem to be holding ground in a rocky market. Fidelity Income Replacement 2036, which is one of the portfolios with the biggest weighting in stocks (61.7%), is down 6.09% vs. 9.29% for the S&P 500 through Jan. 25.

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