Vanguard’s 7% Forever Funds

October 3, 2007

Vanguard recently announced plans to launch three new managed payout funds. Managed payout, managed distribution, or level-rate dividend policies mean the mutual fund company decides how much the fund’s distributions will be, or manage the portfolio specifically to create a certain distribution payment stream. With most mutual funds irregular capital gains and dividend distributions are the result of income and realized capital gains building up in the fund portfolio. According to Vanguard, their highest payout fund is:

…geared toward investors who seek a higher payout level to satisfy current spending needs while preserving their capital over the long term. This fund is expected to sustain a managed distribution policy with a 7% annual distribution rate…"

This move by Vanguard brings a little legitimacy to a sometimes questionable strategy used primarily by closed end funds to give investors the illusion of steady yield.

As investors retire, they want regular returns so they can live off their portfolio. Stocks offer growth to beat inflation, but little in the way of regular income – even a fund made up of the highest yielding common stocks in the market delivers under 4% today. Bonds offer slightly more yield, but no principal growth to offset 30 retirement years of inflation.

Vanguard’s new funds will attempt to address this problem. They will be formulated with the right asset mix to allow monthly liquidation at a rate as high as 7% a year with minimal principal downside.

The proposed Vanguard Managed Payout Funds will be structured as funds-of-funds, investing predominantly in Vanguard domestic and international stock index funds, bond and REIT index funds, and inflation-protected securities and money market instruments. The funds may also allocate a portion of their assets to commodity-linked investments, as well as pursue market-neutral and other absolute-return strategies."

The problem is that this is easier said than done. Historically the proposed asset mix has performed very well with each investment option uncorrelated enough to allow a 7% withdrawal with minimal portfolio volatility (stocks down, REITs and commodities up, etc). Whether this formula will work going forward (now that REITs, bonds, small caps, emerging markets, and commodities have gained significantly) remains to be seen. As for market neutral portfolios – no fund company has ever delivered a market neutral portfolio that could withstand a 7% withdrawal rate long term without principal erosion.

Too avoid simply giving investors their money back – called return of capital – Vanguard may be forced into tricks to produce dividends and capital gains (at the expense of net asset value) to maintain a high payout during rough market periods. Today there are dozens of closed end funds that have high payouts but steadily eroding NAVs – the result of creating yield where it does not naturally exist.

Even the mighty Vanguard 500 Index fund (VFINX) – a fund that any lower risk diversified fund of funds will have a tough time beating over the long term – wouldn’t have been able to deliver a steady 7% managed payout. If you had invested $10,000 in VFINX at the end of 1996 and had drawn down 7% each year (including dividends), you would have a little less than your initial $10,000 investment at the end of 2006. You’d be much worse off if you started a level payout strategy with VFINX in 2000. Today your principal would be far below your starting amount and current payouts would be around 4% of your $10,000 original investment..

Investors want stock market returns with bond market yields and downside risk. This doesn’t really exist in the long run. It’s unlikely Vanguard can create a fund delivering big 7% payouts with principal preservation and stability.