Income-Replacement Funds Target Retirees

The federal government estimates 78 million boomers have socked away a whopping $7.6 trillion in various investments and accounts. Nevertheless, many of them still worry their individual savings won't last as long as they do. The mutual-fund industry has tried to calm those fears — and make some profits at the same time — by launching so-called "asset allocation" and "target date" funds that free investors from making potentially bad portfolio decisions that could cost them thousands of dollars.

Now, several fund families are taking that idea a step further. Last August Fidelity launched a series of "income replacement" funds and later this year Vanguard will come out with competing "managed payout" offerings. (Schwab and John Hancock are also in the mix.) These products, which will pay out monthly income for a set period of time, borrow from the principles behind a range of familiar investments, including annuities, traditional pension plans and existing mutual funds. That makes them reasonably easy to understand. However, any time the industry's major players pile into the same niche, investors need to first determine if their products are a good buy or just the latest fad.

At the heart of these new-fangled retirement funds is an old, needling question for many retirees: How long will my money last? The problem with answering it is that there are too many fluctuating variables. There's considerable uncertainty surrounding Social Security. Fidelity estimates a couple retiring today will need around $215,000 just to cover health-care costs during their golden years. According to consultancy firm Hewitt, that amount exceeds what most 60-year-olds making under $100,000 a year have in their accounts. This year, in particular, is a bad one for retirees. Rising inflation fears and a downturn in the market means many investing accounts have lost value. Even an investor who has smartly saved his entire career risks shaving off years of potential income down the road by tapping a nest egg at its lowest point.

Financial planners suggest retirees withdraw 4% a year from their accounts to pay for living expenses, health care and the occasional vacation. Ideally, their accounts generate a return of at least 7% a year so that they cover those withdrawals and inflation. That would also prevent account owners from eating into their principal.

The industry has plenty of options to accomplish that task, each containing both pros and cons. Retirees could purchase an annuity that would generate a guaranteed flow of income. But these products can be costly and complicated. So-called asset allocation funds — those labeled conservative, moderate and aggressive — allow investors to adjust their risk tolerance as they grow older. However, investors need to do homework to know when to switch out of one fund and into another. Target-date funds automatically rebalance between stocks and bonds the closer they get to a specified year, typically the year a fund owner retires. Since the companies that run target-date offerings do the decision making, they alleviate investors from making potential costly mistakes. The funds, though, wedge investors of every stripe into the same model portfolio. That means an ultraconservative investor and one who isn't afraid to play the market are treated in the same fashion.