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Are Income Replacement Funds Better than Annuities?

A reader writes in, asking:

“My question is in regards to income replacement funds. What do you think of them?  Are they better than an annuity?  I like that fact that you can get to your money if you want to do so.”

I like the idea of such funds. But I haven’t seen one yet that I’ve been particularly fond of.

As a bit of background, the idea behind income replacement funds (at least, Fidelity’s “Income Replacement” funds and Vanguard’s “Managed Payout” funds) is that they’re funds-of-funds that have unique (and potentially convenient) distribution schedules.

  • Fidelity’s Income Replacement funds seek to distribute the entire balance by the date in question (e.g., by 2030 for the Income Replacement 2030 Fund). In other words, if an investor was spending every dime that the fund distributed, she would deplete her holding by the date in the name.
  • Vanguard’s Managed Payout funds do not seek to deplete the fund balance. Rather, they seek to maintain the fund balance (or, in the case of the more growth-oriented funds, have the balance grow) while providing a steady (or, in the case of the more growth-oriented funds, a growing) level of income for an indefinite period.

In other words, relative to using a regular all-in-one fund (e.g., Vanguard’s Target Retirement Income fund) and taking monthly (or quarterly, or annual) distributions yourself, what income replacement funds provide is additional convenience, but not any additional safety.

In exchange for that convenience, rather than the 0.17% expense ratio of the Vanguard Target Retirement Income Fund, they carry expense ratios ranging from 0.34% at the low end (for Vanguard’s Managed Payout Growth Focus Fund) to 0.75% at the high end (for Fidelity’s Income Replacement 2032 Fund). In other words, your investment costs are at least doubling by using such a fund.

And if any of your money is in a taxable account (as opposed to IRAs or other tax-sheltered retirement accounts), these funds still have all the tax-inefficiencies that come with funds of funds as compared to a DIY portfolio using a few individual index funds.

As Compared to Annuities

Unlike income replacement funds, lifetime annuities do provide additional safety as well as convenience. The level of income that they’re promising is guaranteed by an insurance company as opposed to being reliant upon the performance of underlying (sometimes risky) investments.

That’s not to say that everybody should be using lifetime annuities. They certainly have their drawbacks — chief among them being the facts that they’re perfectly illiquid and that the money disappears when you die.

On the other hand, it’s worth remembering that lifetime annuities are able to provide a higher level of income than you can safely take from a typical stock/bond portfolio precisely because the money disappears when the annuitant dies. Instead of going to the annuitant’s heirs, it goes to fund the payments for still-living annuitants.

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Comments

  1. I looked closely at the Vanguard Managed Payout funds and found them lacking. In addition to the higher management fees that Mike Piper discussed, they also return a large percentage of your principal in each monthly distribution. In other words, much of your monthly payment is not from investment profits, but rather is just paying you your money back. Seems to me that it doesn’t take much time or skill to manage a simple portfolio of index funds and easily beat this performance. Annuities are all about betting on how long you will live: if you beat the average, they are a good deal, but 50% of us will die before we get get more money from them than if we kept it ourselves. I suggest learning basic skills for managing your investments or hiring somebody who charges low fees and adheres to the philosophy of simple index fund/ETF portfolios is a better solution.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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