In my last post, I introduced the new Vanguard Retirement Income ETF Portfolio (VRIF), an asset allocation ETF designed for people drawing down their portfolio to meet regular expenses. VRIF holds an equal mix of stocks and bonds and will pay regular distributions with a target of 4% annually.
VRIF isn’t fundamentally new: it’s an example of a monthly income fund, a product that’s been extremely popular in Canada for more than two decades. Whereas traditional mutual funds and ETFs often make quarterly distributions that vary unpredictably, monthly income funds have consistent cash payouts. For example, the fund might set its payout at $0.10 per unit, so if you own 5,000 units you’ll collect $500 every month, regardless of the ups and downs of the market. This has obvious appeal for retirees and others who rely on predictable cash flow to pay their bills.
Monthly income funds can offer convenience and simplicity, but they might be the most widely misunderstood products in the investment industry. I think there are two reasons for this. First, the funds themselves are complicated, as the monthly distributions come from different sources, and this isn’t obvious to most unitholders. (Though I hope it will be by the end of this article.)
The second reason monthly income funds are problematic comes down to a behavioural bias. Many investors love the idea of yield: any time a fund pays a juicy distribution it attracts attention, and we’ve already seen this in the reaction to VRIF’s targeted distribution of 4%.
Some have welcomed that 4% payout as a huge improvement over Vanguard’s other asset allocation ETFs, which typically have yields closer to 2%. At the other end of the spectrum, some have asked why anyone would settle for a measly 4% when there are competitors that yield 5%, 6%, or even much more. Both arguments are misguided.
In order to make an informed decision about whether VRIF (or any other monthly income fund) is an appropriate choice for your retirement portfolio, it’s crucial to understand how it generates that 4% yield. Only then can you compare it with other options.
The four pillars of cash flow
To set the stage here, let’s be clear that a monthly income fund starts out like every other balanced portfolio: it’s just a mix of plain old bonds and stocks. Indeed, seven of VRIF’s eight underlying holdings are the same funds used to build VBAL and VGRO, Vanguard’s two most popular asset allocation ETFs. If all of these portfolios use similar building blocks, how can VRIF deliver almost twice the yield?
To answer that fundamental question, we need to understand that a fund’s cash distributions can come from four different sources:
- interest from bonds
- dividends from stocks
- capital gains from selling those bonds and stocks
- return of capital
The first two are obvious. Bonds make regular interest payments, and many stocks pay dividends, and this cash is paid out to the fund’s unitholders. In many traditional balanced funds, virtually all of the cash distributions come only from these two sources. That’s the case with VBAL and VGRO, and it explains why the yield on these ETFs is only about 2%: that’s all the underlying bonds and stocks pay in interest and dividends.
As we’ve noted, VRIF has similar holdings to VBAL and VGRO, so its cash flow from interest and dividends must also be similar. Indeed, Vanguard expects these two sources to make up only 60% of VRIF’s distributions, which works out to 2.4% in interest and dividends (60% x 4% = 2.4%). The remaining 1.6% has to come from somewhere else.
That brings us to our third source of cash flow: capital gains. In a traditional balanced fund, when stocks or bonds are sold at a profit, the manager usually reinvests the proceeds. But monthly income funds routinely pay out some or all of the proceeds to the unitholders in cash as part of the monthly distribution.
Now it should be clear why VRIF’s yield is expected to be so much higher than that of VBAL and VGRO. Since VRIF is specifically designed for investors who want cash flow, the fund will pay at least some of its capital gains in cash, boosting the distribution yield accordingly. Investors in VBAL and VGRO (presumably) have less of a preference for cash flow, so the managers will reinvest the proceeds of any capital gains realized within the fund.
There’s another important point to understand here. Balanced funds typically only realize gains when they have no choice: for example, if they need to rebalance the portfolio after a big market rally. By contrast, monthly income funds such as VRIF will be actively on the lookout for capital gains to harvest, because they need these to generate cash flow. VRIF should be expected to realize capital gains every year, or at least to try.
But, wait, you say. What if there are no capital gains during the year? Surely a balanced portfolio is going to experience negative returns from time to time, and there may be no opportunity to sell holdings that have appreciated in value during the year. That’s true, but this will happen less often than you might think. For example, one of the holdings might have appreciated by 15% last year, so even if it falls 8% this year it might still have an unrealized gain that can be trimmed. And in a globally balanced fund like VRIF, it’s quite possible that one or two of the individual holdings could go up in a year when the fund’s overall return is negative. It’s rare for all asset classes to decline at the same time.
Remember that VRIF only needs to realize modest gains (about 1.6% annually) to meet its distribution target, and that should be possible in most years. In fact, based on its backtesting, Vanguard estimates they’ll be unable to do so only about once every 10 years or so.
Income that isn’t really income
And what happens in a year where there aren’t sufficient gains in the fund? This brings us to the fourth potential source of cash flow in a monthly income fund. If VRIF is not able to realize enough capital gains to top up its distribution to 4%, then it will make up the shortfall by simply paying unitholders with some of their original investment. This kind of cash flow is called return of capital (ROC).
Savvy investors understand that return of capital might feel like income, but it’s not like interest, dividends or capital gains. Think of it like this: if you deposit $1,200 in a chequing account and then withdraw $100 a month for year, is that account generating income? Of course not: it’s just an illusion. If you spend that $100 every month you’ll be broke at the end of the year, and if you reinvest it you’d just be back where you started. That’s why ROC is not taxable: because it’s not real income. It’s also why every $1 paid out in ROC causes the fund’s value to fall by $1, resulting in an investment return of zero.
Return of capital is not an inherently bad thing, but it can cause at least two potential problems.
First, it can mislead investors, because it’s largely invisible. When those cash distributions hit your account every month, you won’t immediately know whether they came from interest, dividends, capital gains or ROC. If you hold the fund in a taxable account, you won’t know this breakdown until you receive your T3 slip at year-end. And if you hold the fund in a registered account, you won’t even get a T-slip, which means you’ll need to visit the fund’s website to look up the details. Most people won’t do that. So if a fund’s distribution includes large amounts of ROC, investors may naively believe their portfolio is generating real income and growth, when in fact the fund is artificially inflating its yield by giving them back their own money.
The second problem follows from the first. Remember that every dollar paid out in return of capital causes the fund’s unit price to fall by the same amount. If your monthly income fund routinely pays out a lot of ROC, the value of your portfolio will fall steadily and your retirement savings will dwindle over time. That might be fine if the decline is gradual and your financial plan has factored this in. But if you’re spending all of those monthly distributions and assuming they’re sustainable throughout your retirement, you might be in for an unpleasant surprise.
The good news for investors considering VRIF is that this fund is very well designed, and its 4% distribution is likely to be sustainable over long periods. The same can’t be said for some of its competitors. I’ll explain more in my next post.