A new type of mutual fund was introduced in late 2007 by the fund industry called managed-payout funds. The goal of these funds is to give retirees a steady stream of income. At the time, they were touted as being an easy way for investors to get regular income payouts, professional money management and relatively low fees. Early players in the managed-payout fund arena were Fidelity, Vanguard, John Hancock, and Charles Schwab.
These funds demonstrate something known as the “sequencing of return problem” for retirees. If a retiree experiences losses early in their retirement, principal is quickly depleted and the amount of time until the retirement portfolio runs out of money is reduced.
Like the new retiree, these funds are being decimated by the stock market plunge. Right out of the gate, these funds are unable to meet their obligations to retirees and are basically returning principal.
"The plight of managed payout funds dramatizes boldly, what can happen to investors if they experience a serious market downturn early on, when they are starting to draw down their payments in retirement," said Dan Culloton, a fund analyst at Morningstar.
The Sequencing of Return Problem
When you are in growth mode, sequence of returns doesn't matter. Regardless of whether a portfolio experiences weak or strong returns early on, the ending market value will be the same.
Let's look at an example:
Assume we have two portfolios, X and Y. Each starts with $500,000. Neither is taking withdrawals. Portfolio X experiences early losses. Portfolio Y experiences early gains. As you can see from the chart below, there is no difference in the ending value.
This is not the case once you begin taking distributions. As you can see from the chart below, Portfolio X experiences losses early on and runs out of money in less than 20 years. Portfolio Y has strong early returns and is still going strong at age 100.
Even though both averaged 6.5% return, the difference in the two outcomes is massive!
This demonstrates the tragic flaw in a traditional capital appreciation portfolio when your investment objective is income replacement. There is just too much dependence on luck. You are basically betting on a random sequence of numbers over 30 years and the consequences if your bet doesn’t pay off, are catastrophic.
How cash flow solves the sequencing of return problem
Capital appreciation is when you buy something in hopes it will go up in price. When it does, you sell it for more than you paid for it, and the profit is called capital appreciation.
Cash flow is money that comes to you while you still own the asset. Examples of cash flow would be rent, royalties, interest, dividends, and option premiums. The key characteristic of cash flow is that you do not have to sell the asset in order to make money.
Another important characteristic of cash flow investments is cash flow is typically tied to the amount invested rather than the market value. Take a bond, for example. The yield is a percentage of the face value. A $1000 bond paying 6% will pay $60 in cash flow whether the bond is worth $900 or $1100.
Cash flow is the blindingly obvious solution to the sequencing of returns problem, among others. Imagine your monthly expenses are $9000 a month and your portfolio generates $12,000 a month in cash flow. So long as the $12,000 is not connected to the market value of the portfolio, the sequencing of return problem goes away. Your portfolio withdrawals would be unaffected by the sequence of return.
Why does Wall Street continue to try to shove the same old square pegs in increasingly round holes, as evidenced by the dismal failure of the managed payout funds? As Robert Frey, an adviser in Bozeman Montana, says, "These funds are dogs." It's time for the capital appreciation model to be put out of its misery.
1. Funds Featuring Managed Payouts Off To Rocky Start. (2009, February 11). InvestmentNews. Retrieved from http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20090201/REG/302019983/1030/MUTUALFUNDS.
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