Optimism risky with 'target distribution'

by Stephen Butler

I've worried about things all my life and nothing really bad has ever happened, so it must be a system that works.

The financial service industry's latest sop to us "worry warts" is the concept of "target distribution" or "managed payout" funds. These are mutual funds that automatically pay out earnings and principal to retirees at a scheduled rate (chosen by the retiree but "monitored" by the fund) and that try to make the money last as long as possible.

The danger here is that people resorting to these funds will probably be too optimistic. Advisors selling them may be like real estate brokers who get the listing first because they tell the seller what the latter wants to hear.

The three greatest challenges of retiree financial management are: 1.) inflation, 2.) longevity and 3.) unlucky sequence of investment results. Since planning for all three involve a prediction of the future, the temptation to be too optimistic can lead to catastrophic results.

The third challenge, unlucky sequence of investments, is the most interesting because the solution is counterintuitive and not addressed adequately by this new type of fund. When someone starts removing money from, say, a retirement account, it is critical that they not lose money in the early years of distribution. The combination of paying out an income AND experiencing an investment downturn is like the magic of compound interest in reverse.

A sustained market downturn such, as the one we had in the early 2000's, would have had a severe impact on any one of these new target distribution funds being sold today. Most just assume that market averages (10 percent for stocks) will prevail. I have yet to see an illustration that shows what would happen to the stream of income given a repeat of the early 2000's. A downturn combined with generous income payouts could reduce an account by 50 percent pretty quickly.

The first 10 years of retirement is when protecting against the downside is the most critical.

For people living to age 90, of which there are 2 million Americans today, more risk could actually be taken later in life when a portfolio's purpose is to create a bequest to heirs. By their mid-eighties, anyone making it that far knows that they are working with a more predictable time-frame than someone age 65. At that point, the time-frame begins to include the life-expectancy of heirs or favorite charities (both of which are arguably infinite.)

Older retirees shouldn't throw all caution to the wind, but they can consider a paradoxical line of thought calling for more risk and greater market exposure as they age like a redwood.

Meanwhile, back to those target distribution funds. Fidelity, Schwab and T.Rowe Price all have them, of course. In Vanguard's version, introduced last month, there is yet another wrinkle which is their use of their market neutral fund (VMNIX) --- a fund that sells short and profits when the market drops in value. This fund was established in 1999 with a minimum investment of $250,000, but by investing in Vanguard's target distribution funds, such as Vanguard managed Payout Distribution Focus, an investor with $25,000 can effectively enter the Market Neutral fund through the back door with at least some of the invested money. The market neutral fund delivered on its promise through the downturn since October, and it did well during the early 2000's.

Vanguard's program will eventually be investing in commodity futures and even a private investment fund --- both investment types that tend to be "inversely correlated" with overall stock market performance. This simply means that when the stock market zigs, these investment types traditionally zag. The net effect is a response to the potential "blind-siding" problem we identified above --- the unlucky sequence of investment returns. More so than its competitors, it looks like Vanguard has concocted an antidote to this hidden hazard of early losses in a retirement income program.

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