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Review of Fidelity Income Replacement Funds

Contributed by mm | October 11, 2007 10:41 PM PST

Having accumulated a big retirement portfolio but uncertain about how you should count on the portfolio to generate regular inflation-adjusted monthly payments? Our innovative financial service industry is not hesitate to help. Introducing the latest innovation in mutual fund industry … Fidelity Income Replacement Funds.

As marketed on the Fidelity web site:

Fidelity Income Replacement Funds are a new type of mutual fund designed to combine the power of professional asset management with professionally managed withdrawals to help turn part of your savings into regular monthly payments. The Funds are designed to be used in combination with other retirement income products and provide:


- Regular monthly payments that seek, but are not guaranteed, to keep pace with inflation
- Flexibility to change your mind at any time; you maintain 100% control of your investments with no additional fees or penalties
- Professional management of your assets and withdrawals
- Transferability of any remaining assets to your heirs, as with all mutual funds


In the hypothetical example included in the video demo, one can invest $100,000 today, and start getting inflation-adjusted monthly payout immediately, starting at $580 in Year 1 (to $680 in Year 6, $950 in Year 12 and $1,425 in Year 20). Expected total payout over the lifecycle of 20 years? Over $216,000.

I'm habitually very interested in analyzing new financial products, and this new product really amazed me, so I dedicated two hours to read the funds' prospectus and run the numbers. So what are my findings?

Mechanism:

Similar to those "lifecycle" funds, Fidelity Income Replacement Funds automatically adjust the allocation of your portfolio toward a conservative mix over time, by investing in a number of underlying equity and fixed income funds.

In addition, Income Replacement Fund provides one more feature: it plans the right monthly withdrawal amount and send the money to you, so you don't have to worry the details of how much to withdrawal and whether your money can survive your lifespan. Fidelity accomplishes this by the Smart Payment Program, which will automatically sell mutual fund shares for you to make the monthly payment to you when necessary.

Let's say Income Replacement Fund is one step closer to a truly lazy man's solution. If you really don't want to work with money, you can set up the Income Replacement Fund, and just leave it to Fidelity to send you the monthly distribution check.

Underlying Funds:

You can not blame Fidelity for only using its own funds to construct each Income Replacement Fund's portfolio. However, it is somehow discomforting to see Fidelity only uses actively managed funds as underlying funds. Shouldn't it consider lower-cost passive index funds?

Here is the list of underlying funds that are used in each Income Replacement Fund.

EQUITY FUNDS

Domestic Equity Funds:
- Fidelity Broad Market Opportunities Fund
- Fidelity Large Cap Core Enhanced Index Fund
- Fidelity 100 Index Fund
- Fidelity Disciplined Equity Fund
- Fidelity Equity-Income
- Fidelity Advisor Mid Cap II
- Fidelity Small Cap Opportunities Fund

International Equity Funds:
- Fidelity International Discovery Fund

FIXED-INCOME FUNDS

Investment-Grade:
- Fixed-Income Funds
- Fidelity Total Bond Fund
- Fidelity Government Income Fund
- Fidelity Strategic Real Return Fund

High Yield Fixed-Income Funds:
- Fidelity Capital & Income Fund
- Fidelity Strategic Income Fund

Short-Term Funds:
- Fidelity Short-Term Bond Fund
- Fidelity Institutional Money Market: Money Market Portfolio

Investment Risk:

However, it is also worth noting Income Replacement Fund is not annuity, and there is no guarantee of whether your monthly payout will match inflation, or even whether you can get a monthly payout at all. Actually, your principal is also at risk since your money will be invested in a number of Fidelity-managed stock and bond funds.

Monthly Payout Prospect:

Here is how you can expect as monthly income in the first year if you invest $1,000,000 into one of the Income Replacement Funds.

Fidelity Income Replacement 2016 Fund (9 years' horizon): $9,290
Fidelity Income Replacement 2018 Fund (11 years' horizon): $7,982
Fidelity Income Replacement 2028 Fund (21 years' horizon): $5,082
Fidelity Income Replacement 2036 Fund (29 years' horizon): $4,240

* If things go smoothly as Fidelity planned, your monthly income will likely to increase every year to account for inflation.

Inflation Estimate:

Fidelity didn't discuss too much about its inflation assumption anywhere in the Funds' literature. The only hint it gave is in the demo video, which seems to suggest that Fidelity assumes about 3% inflation in the new five years, and 5% inflation thereafter. However, it is important to note that Fidelity will not peg year-over-year monthly income growth to CPI or any other price index; your 2nd year's monthly income is more a result of investment results in the first year.

Expense:

Fidelity's series of Income Replacement Funds carries a reasonable fee structure. The only expense you will incur is those from the underlying funds. In other words, you don't pay a second-tier fee for the benefit of arranging

As stated in the prospectus, Income Replacement Funds carry an annual expense % between 0.54% (for 2016 Fund) to $0.65% (for 2036 Fund).

Tax:

Handling the tax consequences for Income Replacement Funds can be hard, especially for the later years of every Fund's time horizon. That is because in later years, some of your monthly payout has to come from selling some mutual funds shares, and without proper reporting from Fidelity, it will be extremely difficult to tell which portion of your monthly income should be classified as dividend, capital gains, or just return of principal.


Conclusion:

I do feel Income Replacement Fund is a nice invention that caters to those who already built their nest eggs, and want a no-hassle solution that will generate inflation-protected monthly income. Of course, potential investors need to know that by expecting better returns than annuity products, there is investment risk involved in the process, and Fidelity's actively managed funds may not the most cost-effective solution.

This Post Has Received 10 Comments. Share Your Opinions Too.


Creative Investor Commented on October 12, 2007

Given the lack of control you'd have in the fund like that, the fees, the fact that Fidelity had more incentive to put you into more expensive funds than better performing funds, I wonder if you'd beat their performance by simply putting your money into a money-market account earning 5%.

Seems like another fund with an "appeal" to a certain market, rather than a better performing investment vehicle. Nice review though.


Rob Commented on October 12, 2007

Sounds like an immediate annuity without all of the fees. Nice to have options. Nice job Fidelity.


MM Commented on October 12, 2007

Creative Investor, if I haven't made it clear, the monthly payment is expected to grow over time, so it's supposed to be better than money market account. I feel this product can appeal to a lot of lifecycle fund owners. BTW, thanks for commenting a lot these days.


Creative Investor Commented on October 12, 2007

MM, well, here is how I look at it: If over time this payment will be exceeding what you would get from a money market account than one or both of the following statements are true 1) the payment will be lower than money market accounts for about half of the time and then higher half of the time, averaging about the same total at the end, and/or 2) they will be using principal to increase the payment.

Basically, my point comes down to this: I don't believe this hodgepodge of Fidelity funds will perform well over time and since money for your payments have to come from somewhere and performance is lacking, they'll have to tap the principal.


P2P-Loans.com Commented on October 14, 2007

Great posting - this is a very interesting product. Do you know if the expense cited in the prospectus includes the built in expense of the funds that reside within the fund? In other words is there double taxation on this fund or is the expense you cite the only one we should be thinking about. Thanks.


MM Commented on October 14, 2007

P2P-Loans: There is no additional expense on top of the underlying funds' expense.


JBW Commented on October 15, 2007

It seems like an intersting product idea and I think it can be a good option for the average person. My concern is the payout amount. Using the amount listed for the 29 year horizon of $4,240 equates to $50,880 per year, or roughly 5.1%. I thought the general rule of thumb was 4% for a 30-year time frame. Is the extra year the difference, am I figuring this incorrectly, or is their payout structure just aggressive? I suppose you could get around this by requesting a longer time horizon in order to get a more conservative payout structure (similar to choosing a later target retirement date in an under-aggressive lifecycle fund).


Daniel Commented on October 15, 2007

Thanks for a good review. I will try to read the perspectus later this week. I have several questions for Fidelity on this one.
1. Have they accounted for any volatility with respect to monthly withdraws?
2. If so, what is the forecasted volitility?
3. Have they ran Monte Carlo analysis to see the probability of monthly income amounts?
In my opinion your portfolio's volatility is probably the most important aspect to control during retirement. Finding the answers to these questions would help us to make a more informed decision. I also agree on the addition on index funds... surely they have read all the studies on actively managed funds?


Swim Upstream to Wealth Commented on October 28, 2007

You can set this up without much effort at Vanguard, Schwab, etc. Just distribute 4% per year and invest so that you get the 4% withdrawal plus the inflation rate. This keeps your monthly payment growing with inflation. Plus, by doing this you can invest in index funds and reduce the internal expense ratio by 20 or 30 bps.


Juan22 Commented on October 30, 2007

Very interesting concept. I had not heard of it before now. Thanks for the article.


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