Are Managed-Payout Funds Better Than Annuities?
July 28, 2015
by Joe Tomlinson
Peter Lynch was one of the best growth investors of all time. As the Magellan Fund manager at Fidelity Investments between 1977 and 1990, he averaged a 29.2% annual return. Q1 2021 hedge fund letters, conferences and more The fund manager's investment strategy was straightforward. He wanted to find growth companies and sit on them Read More
Managed-payout funds promise to meet retirees’ need for sustainable lifetime income without relying on annuities. To see whether this promise can be fulfilled, I’ll answer three questions: What’s the best design for such funds? How do they compare to annuities? Can retirees do even better by combining managed-payout funds and annuities?
A managed-payout fund aims to provide sustainable retirement income, either over a fixed time horizon or over the lifetime of the investor. A handful of companies offer managed-payout funds and more are on the way. The funds have not gained much popularity because most were launched just before the financial crisis and immediately produced poor results.
PIMCO offers real-income funds based on TIPS ladders but with end dates, so the funds don’t offer longevity protection. Fidelity’s Retirement Income Series also uses target-liquidation dates. Vanguard’s Managed Payout Fund is more lifetime focused with payouts targeted at 4% of fund balance. Schwab offers Monthly Income Funds that, like Vanguard, pay out a percentage of the fund balance. However, Schwab varies the percentage payout to avoid dipping into principal, whereas Vanguard smooths results over multiple years and aims to maintain the 4%. The latest entry in this category is the retirement spending account from Natixis. It is the most ambitious approach with a goal of providing inflation-adjusted retirement income for life but without an annuity.
Finding the best strategy
There is a natural question that arises from examining these different offerings: “Which strategy will work best?” By “working best,” we need to consider both the level of income produced and the risk that the strategy will fail. I’ll answer those questions by evaluating a few generic options and relate my results to specific fund offerings.
There are a variety of strategic choices for those designing managed payout funds:
- Income generated – fixed at inception or varying with investment performance
- Stock/bond allocation
- Use of additional asset classes
- Investment glide path – level, increasing or decreasing stock allocation
- Annual withdrawal percentages – level or varying with age
I’ll use an example to compare the impacts of various choices with the objective of identifying the best ways to produce as much income as possible without taking undue risk.
This example is based on a 65-year-old female with a remaining life expectancy of 25 years. She has $1 million in savings and will be receiving $20,000 per year in Social Security. Her essential expenses are $50,000 per year increasing with inflation, so she needs to generate at least $30,000 per year in real terms to pay for essentials. I assume that she has sufficient insurance for contingencies such as long-term care and a separate emergency fund, so she can devote the full $1 million to generating retirement income.
In designing generic options for this example, I assume that stocks will earn a real return averaging 5.15% with a standard deviation of 20.5% and bond real returns will average 0.5% with a 7% standard deviation. These assumed returns are significantly below historical averages, reflecting current interest rates and a lower-than-historical equity risk premium. I deduct 0.15% as a base level for investment expenses and discuss the implications of higher expenses for actual product offerings. Monte Carlo simulations are used to generate yearly returns, and the year of death is also modeled stochastically. The analysis is pre-tax and future dollar figures are stated in real terms without inflation.
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