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Distribution Funds: Putting Income on Autopilot

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Distribution Funds: Putting Income on Autopilot

April 21, 2014

TP-IV-30_01As baby boomers retire, they begin to focus less on accumulating assets and more on how those assets can be converted into an ongoing stream of income. Distribution funds are one way to simplify that process.

Distribution funds are actively managed mutual funds that focus not on maximizing asset growth but on making regularly scheduled payments to investors. Distribution funds were primarily designed to give retirees an easy way to receive income. For example, early retirees might use one to provide income until they reach full retirement age. They also can be used to complement a pension or other income sources.

How distribution funds work

A distribution fund basically functions much like a systematic withdrawal plan. Its annual payout (either a percentage of assets or a specific dollar amount) is divided into equal payments that are scheduled to be made at regular intervals (typically monthly or quarterly).

As with so-called lifestyle or lifecycle funds, distribution funds typically are offered as part of a group. All funds in the group use a similar investing methodology, but each fund has a different payout target or distribution rate. For example, one fund in the group might offer a 3% annual payout. Another fund in the same group might target a 4% payout, and a third might aim for 6%.

One size doesn’t fit all

Even though funds within a given series are consistent in their approach to income distribution, methods used by various families of distribution funds to generate returns and calculate payments vary widely. For example, one series might differentiate its funds based on the annual percentage each one distributes. Another group of funds might determine annual income levels and asset allocation based on how long each fund’s portfolio is intended to last. The shorter a fund’s time horizon, the higher the targeted annual payout.

A fund by any other name

Distribution funds also may be referred to as:

• Managed income funds
• Retirement income funds
• Income replacement funds
• Managed payout funds
• Retirement distribution funds

Some distribution funds are managed so that all capital is exhausted by the end of a designated time period, generally getting more conservative as that end date gets closer. Others are designed to preserve capital and make payouts primarily from earnings; these typically have no time frame attached. Regardless of how the targeted payout rate is derived for a given fund series, it’s based on what is considered a sustainable withdrawal rate given the fund’s objectives, planned asset allocation, and time frame (if applicable). Also, in some cases, the amount of the payout is adjusted to keep pace with inflation.

A distribution fund’s method of providing its targeted income is generally based on historical rates of return for various types of investments in both good and bad markets. Each fund’s strategy is intended to minimize the impact of market fluctuations on its income payout. However, there is no guarantee a fund’s payout will remain the same from year to year. Also, it’s important to remember that all investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful.

Questions to ask about a distribution fund:

• How are monthly payments determined?
• Does the fund make payments from earnings only, or from both earnings and principal?
• What is the proposed withdrawal rate?
• How much risk does the fund take in trying to achieve its targeted distribution rate?
• What are the fund’s underlying investments?
• What is the fund’s current asset allocation, and how may that allocation change over time?

A distribution fund is generally structured as a fund of funds, meaning that it is comprised of other mutual funds. However, some also include other types of investments.

Distribution funds aren’t annuities

Because of their focus on income, distribution funds are designed to fill a role in retirement that is somewhat similar to that of annuity payments. However, there are some key differences. Perhaps the most important is that distribution funds offer no guarantees of the payout levels they offer; annuities generally do (subject to the claims-paying ability of the annuity’s issuer). Also, a mutual fund is not an insurance contract, as an annuity is. And annuities often are designed to ensure an income that lasts throughout an individual’s lifetime, and/or that of a spouse. Though an investor can attempt to provide that with an appropriate distribution fund, no fund can guarantee income for life.

Advantages of distribution funds

A distribution fund can simplify and streamline the process of receiving ongoing income. You don’t have to worry about constructing that diversified portfolio yourself, shifting its asset allocation over time, or rebalancing it periodically. Also, the concept of a distribution fund may be easier to understand than an insurance contract that has many riders and variables. In addition, a targeted payout rate may make it easier to estimate how long your savings will last than if you were to try to manage your portfolio on your own.

Distribution funds also offer a great deal of flexibility. Even though you receive regularly scheduled payments, you can withdraw additional amounts from your principal at any time. That means you can adjust your annual retirement income from year to year, or make withdrawals to take care of unexpected costs. Investments that guarantee a regular income stream typically restrict the use of your principal.
Because distribution funds were intended as low-cost alternatives to annuities, expense ratios tend to be comparatively low.

Tradeoffs with distribution funds

As mentioned previously, a distribution fund may strive to provide a certain level of income, but there are no guarantees that it will do so. Depending on how a fund is structured and managed, a steep or prolonged market decline could affect the amount of the scheduled payments from year to year, or how long your investment will last. If you cannot afford either possibility, a distribution fund may mean more uncertainty–either long term or short term–than you’re comfortable with.

If you are willing and able to structure and administer a systematic withdrawal program independently, you may be able to replicate many of the advantages of a distribution fund with a well-diversified portfolio. That would give you greater ability to customize payouts to your individual situation. For example, you could shift investments based on what’s happening in the financial markets or your own life, and manage your tax situation from year to year.

Distribution funds are designed for individuals who plan to stay invested in a given fund for an extended period of time. If you’re an active trader or might withdraw your money relatively quickly, you may want to think twice; in-and-out investing will undercut the very reason for choosing a distribution fund. And be aware that even though you can withdraw amounts over and above your scheduled payments, those withdrawals will reduce future earnings that would have supported distributions in later years. That could leave you vulnerable to longevity risk–the possibility of outlasting your savings.

You also may need to consider any projected distribution fund payouts in the context of other retirement income concerns, such as the tax consequences of those payouts, or required minimum distributions from a qualified retirement plan or IRA.

One of many choices

Before investing in a distribution fund, carefully consider its investment objectives, risks, charges, and expenses, which can be found in the prospectus available from the fund. Read the prospectus carefully before investing. As with most investment options, a distribution fund may not fill all your retirement income needs. Don’t hesitate to get expert advice on whether one might be useful for part of your portfolio, or for a specific purpose.

Note: Past performance is no guarantee of future results and asset allocation alone can’t guarantee a profit or prevent a loss.

IMPORTANT DISCLOSURES
Altum Wealth Advisors does not provide investment, tax, or legal advice via this website. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, this notice is to inform you that any tax advice included in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of avoiding any federal tax penalty or promoting, marketing, or recommending to another party any transaction or matter.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014.

Prepared for Altum Wealth Advisors, Steven Cliadakis, MBA, CWS®, Managing Director, Wealth Strategist.

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Bonds vs. Bond Funds: Which Is Better When Interest Rates Rise?

January 10, 2014

The Federal Reserve has said it expects to begin raising its target rate sometime in 2014. Since bond prices fall when interest rates rise, it may be a good time to pay increased attention to any fixed-income investments you have. Here are some factors to consider when you review your portfolio.

Maturity dates and duration

NIV-bondfunds0114_01One way to address the threat of rising rates is through maturity dates. Long-term bonds may pay a higher coupon rate than short-term bonds, but when rates rise, long-term bond values typically suffer more. That’s because investors may be reluctant to tie up their money for long periods if they expect a bond’s interest payments may suffer by comparison when newer bonds that pay higher rates are issued. The later a bond’s maturity date, the greater the risk that its yield eventually will be surpassed by that of newer bonds.

A bond fund doesn’t have a maturity date, and your shares may be worth more or less than you paid for them when you sell. However, there is another way to gauge the sensitivity of either a bond or a bond fund to interest rates: its duration, which takes into account not only maturity but also the value of future interest payments. The longer the duration, the more sensitive a security is to interest rate changes.

To estimate the impact of a rate change, simply multiply a security’s duration by the percentage change in interest rates. For example, if interest rates rise by 1%, a bond or bond fund with a duration of 3 years could be expected to lose roughly 3% in value, while one with a 7-year duration might fall by 7%. (Though interest rates currently have little room to fall, the same principle would apply; a 1% decline in rates should result in a 3% gain for a bond fund with a 3-year duration.) Though this hypothetical example doesn’t represent the return of any specific investment, you can apply the general principle to your own holdings.

Diversification

Since rising rates affect most bonds, diversification provides only limited protection against rate increases. To balance yields with the threat of rising rates, you can diversify across various segments of the bond market (for example, investment-grade corporate, high-yield, Treasuries, foreign, short/intermediate/long-term, and municipal debt). Bonds don’t respond uniformly to interest rate changes. The differences, or spreads, between the yields of various types can mean that some categories are under- or over-valued compared to others. Funds may offer greater diversification within each segment at a lower cost than individual bonds, providing greater protection against the impact of a potential default by a single issuer. However, diversification alone doesn’t ensure a profit or prevent the possibility of loss, including loss of principal.

Flexibility

Holding individual bonds allows you to sell a specific bond on your own timetable or hold it until it matures. That flexibility has two advantages. First, if you hold to maturity, unless a bond’s issuer defaults, you know how much you’ll receive when the principal is repaid. Rising interest rates may cause a bond’s market value to fluctuate in the meantime, but if you hold it to maturity, that fluctuation may not be an issue for you, especially if predictable income is your highest priority.

Second, it can help you manage your tax liability; if a specific bond has lost value, you can sell it and declare the loss on your federal income tax return. You may be able to instruct your broker to sell specific shares of a bond fund to harvest losses for tax purposes, but in general it’s more challenging to manage tax liability as precisely with bond funds. For example, capital gains or losses generated by a fund manager’s trading are passed through to individual shareholders each year, which can affect your tax liability. Also, a bond fund’s value can be affected by your fellow investors. Since an open-end fund must redeem investors’ shares daily, strong selling can force a fund to sell holdings to meet redemption demands, which can have implications for other shareholders.

Laddering individual bonds also can help provide flexibility to adjust to rising rates. Laddering involves buying a portfolio of bonds with varying maturities; for example, a five-bond portfolio might be structured so that one of the five matures each year for the next five years. As interest rates rise, each bond that matures can be reinvested in a newer instrument that offers a higher yield.

Liquidity

A mutual fund will redeem your shares at the end of every business day. An individual bond traded on the open market may not have the same liquidity, and you could have difficulty finding a buyer who’s willing to pay the asking price. However, individual bonds are priced and traded throughout the day; only closed-end funds and exchange-traded funds have that flexibility, not open-end mutual funds.

IMPORTANT DISCLOSURES

Altum Wealth Advisors does not provide investment, tax, or legal advice via this website. The information presented here is not specific to any individual’s personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, this notice is to inform you that any tax advice included in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of avoiding any federal tax penalty or promoting, marketing, or recommending to another party any transaction or matter.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014.

Prepared for Altum Wealth Advisors, Steven Cliadakis, MBA, CWS®, Managing Director, Wealth Strategist. Chico, CA, San Francisco, CA.

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The Impact of Health-Care Costs on Social Security

January 10, 2014

For many retirees and their families, Social Security provides a dependable source of income. In fact, for the majority of retirees, Social Security accounts for at least half of their income (Source: Fast Facts & Figures About Social Security, 2013). However, more of that income is being spent on health-related costs each year, leaving less available for other retirement expenses.

The importance of Social Security

NPT-HEALTHSSI0114_02

Social Security is important because it provides a retirement income you can’t outlive. In addition, benefits are available for your spouse based on your benefit amount during your lifetime, and at your death in the form of survivor’s benefits. And, these benefits typically are adjusted for inflation (but not always; there was no cost-of-living increase for the years 2010 and 2011). That’s why for many people, Social Security is an especially important source of retirement income.

Rising health-care costs

You might assume that when you reach age 65, Medicare will cover most of your health-care costs. But in reality, Medicare pays for only a portion of the cost for most health-care services, leaving a potentially large amount of uninsured medical expenses.

How much you’ll ultimately spend on health care generally depends on when you retire, how long you live, your health status, and the cost of medical care in your area. Nevertheless, insurance premiums for Medicare Part B (doctor’s visits) and Part D (drug benefit), along with Medigap insurance, could cost hundreds of dollars each month for a married couple. In addition, there are co-pays and deductibles to consider (e.g., after paying the first $147 in Part B expenses per year, you pay 20% of the Medicare-approved amount for services thereafter). Your out-of-pocket yearly costs for medical care, medications, and insurance could easily exceed thousands of dollars.

Medicare’s impact on Social Security

Most people age 65 and older receive Medicare. Part A is generally free, but Parts B and D have monthly premiums. The Part B premium generally is deducted from your Social Security check, while Part D has several payment alternatives. In 2013, the premium for Part B was $104.90 per month. The cost for Part D coverage varies, but usually averages between $30 and $60 per month (unless participants qualify for low-income assistance). Part B premiums have increased each year and are expected to continue to do so, while Part D premiums vary by plan, benefits provided, deductibles, and coinsurance amounts. And, if you enroll late for either Part B or D, your cost may be permanently increased.

In addition, Medicare Parts B and D are means tested, meaning that if your income exceeds a predetermined income cap, a surcharge is added to the basic premium. For example, an individual with a modified adjusted gross income between $85,000 and $170,000 may pay an additional 40% for Part B and an additional $11.60 per month for Part D.

Note: Part C, Medicare Advantage plans, are offered by private companies that contract with Medicare to provide you with all your Part A and Part B benefits, often including drug coverage. While the premiums for these plans are not subtracted from Social Security income, they are increasing annually as well.

The bottom line

The combination of rising Medicare premiums and out-of-pocket health-care costs can use up more of your fixed income, such as Social Security. As a result, you may need to spend more of your retirement savings than you expected for health-related costs, leaving you unable to afford large, unanticipated expenses. Depending on your circumstances, spending more on health-care costs, including Medicare, may leave you with less available for other everyday expenditures and reduce your nest egg, which can impact the quality of your retirement.

IMPORTANT DISCLOSURES

Altum Wealth Advisors does not provide investment, tax, or legal advice via this website. The information presented here is not specific to any individual’s personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, this notice is to inform you that any tax advice included in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of avoiding any federal tax penalty or promoting, marketing, or recommending to another party any transaction or matter.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014.

Prepared for Altum Wealth Advisors, Steven Cliadakis, MBA, CWS®, Managing Director, Wealth Strategist. Chico, CA, San Francisco, CA.

Continue Reading