The newly launched Vanguard Retirement Income ETF Portfolio (VRIF) is designed to pay its unitholders a consistent monthly cash flow equal to a 4% annual yield. In my last post, I explained how these distributions will primarily come from interest, dividends and capital gains, with only small amounts of return of capital (ROC). Indeed, Vanguard expects to pay return of capital—which is essentially giving you back some of your original investment—only about once every 10 years.
Understanding the source of the payouts from monthly income funds is important, because it can help you determine whether the yield is sustainable. At the most basic level, a portfolio that yields 4% annually will only be sustainable if its long-term total return is at least that much. Total return is the combination of interest, dividends and capital gains or losses, whether these are paid out in cash or reinvested in the fund.
We know the interest and dividends paid by the bonds and stocks in VRIF fall far short of 4% (Vanguard is targeting 2.4%), so there is also some expectation of capital gains. If these gains are not sufficient, the fund will need to top up its monthly distribution with ROC, which causes the unit price to fall. If this becomes a long-term pattern, investors who spend all of those monthly distributions can face a big problem. Namely, they can run out of money.
Unfortunately, this is a chronic problem with some monthly income funds: they advertise juicy yields of 6%, 7%, or even more, but a big chunk of the payout is ROC. The unit prices of these funds have been falling for years (even during bull markets), which means the payouts are probably not sustainable.
Let’s take a deeper dive into this common flaw in monthly income funds. Then we’ll look at the strategies VRIF uses to avoid falling into the same trap.
ROC and a hard place
Dan Hallett of HighView Financial Group has written about unsustainable yields for years. Back in 2011 he called out the BMO Monthly Income Fund for paying a distribution that had ballooned to 9.5%, much of which was ROC. Hallett estimated that about two-thirds of those cash payouts were being reinvested, but the other third was likely used to meet the expenses of unitholders. Presumably at least some of those investors believed they were “not touching their capital,” when in fact they were grinding it down every year.
As Hallett predicted, BMO eventually had no choice but to cut the distribution. Today, the flagship version of the BMO Monthly Income Fund has a far more reasonable yield of about 4.3%. However, another version of the fund (with the same underlying holdings) has a targeted 6% distribution, even though its total return was barely 4% over the last five years. And the version Hallett called out so many years ago still exists, though it’s mercifully closed to new investors. Its current yield is more than 12%, and its unit price has fallen almost 50% since 2013. Let’s hope the remaining investors aren’t still under the illusion they’re not digging into their capital.
Monthly income funds with such unsustainable payouts are a rarer these days, but they still exist. Perhaps the most egregious example is the Canoe EIT Income Fund (EIT.UN), which pays a monthly distribution of $0.10. That’s a pornographic yield of over 13%, which explains how it has attracted $1.1 billion in assets. Over the last 10 years (ending August 31), the fund’s total annualized return was 5.8% as the fund’s unit price fell more than 38%, from $15.42 to $9.50. How long before it’s forced to slash that distribution?
The diff with VRIF
OK, back to VRIF. I’ve spent all this time highlighting the potential dangers of monthly income funds because I want to emphasize how VRIF is different. Let’s look at why its yield is likely to be sustainable over long periods.
First, as I’ve said, a fund can only pay out a 4% distribution sustainably if its total return is at least that much over the long term. Those returns can be inconsistent and occasionally negative: a portfolio of stocks and bonds can never be expected to deliver steady, uninterrupted growth. But over a decade or three, the fund’s expected return should be at least as high as its targeted distribution. Does VRIF’s 4% pass that test?
I think it does. Today VRIF has an asset mix of 50% bonds and 50% stocks and a fee of 0.29%. Estimating future returns for balanced portfolios is always problematic, of course, but anyone with a financial plan needs to make reasonable assumptions. Our firm uses a methodology that combines historical returns with current valuations, which we update twice a year. We’re currently using a return estimate of 4.2% before fees for a 50/50 portfolio, so VRIF’s target is in that ballpark. (Over the long term, Vanguard has said it is aiming for a 5% total return.)
There’s another important feature investors should understand about VRIF: that 50/50 asset allocation isn’t static. Nor is the breakdown of the eight individual ETFs in the fund. For example, international equities now make up 22% of the portfolio, while emerging markets are just 1%. Global bonds and corporate bonds also get more than 20% each, while Canadian and US broad-market bonds get a trivial 2%. These differences seem extreme, but the mix will evolve over time.
Vanguard has said it will use its own research on valuations and long-term expected returns to adjust VRIF’s asset allocation, with small adjustments from month to month and larger changes as often as quarterly. The managers have the leeway to shift the overall equity allocation to as much as 60%, or as little as 30%.
If interest rates rise, for example, one should expect the fixed income allocation to get larger. If the gap between the yield on government and corporate bonds narrows, the large allocation to corporate bonds might get smaller. If the high valuation of US stocks declines, that asset class might get a bigger share. And so on.
Does this “time-varying asset allocation” make VRIF an actively managed fund? Well, that’s up to you to decide. It’s certainly more active than Vanguard’s other asset allocation ETFs, such as VBAL and VGRO, which have unchanging targets.
The 4% solution
There’s one final aspect of VRIF that investors need to understand. It’s the one that makes its distributions more sustainable than those of its competitors. As we’ve seen, monthly income funds can get into trouble when they pay a fixed dollar amount year after year, even as the fund’s unit price steadily falls. VRIF’s distribution policy ensures that can never happen.
When the fund was launched in September, it had a unit price of $25, so the targeted 4% yield was $1 annually, or $0.0833 per month. But this will get adjusted every year. For example, if at the at the end of 2020 the fund’s unit price has declined to $24.50, the 4% distribution will be recalculated at $0.98, and the 12 monthly distributions for 2021 will be $0.0817 per unit. If the price has climbed to $25.50, then the annual 4% yield will be $1.02, or $0.085 a month.
Because VRIF’s unitholders will be looking for consistent cash flow, Vanguard will cap these annual changes at 5% in either direction. So if you hold 12,000 units today and you’re receiving $1,000 a month in income, you can be confident that next year your monthly distribution will be between $950 and $1,050.
This policy means VRIF’s cash flow is a bit less predictable than some other monthly income funds. Following a year of negative returns, investors might need to adjust their spending downward, though they could enjoy a little more consumption after a period of high returns. But the adjustments are only once a year, and the 5% limit means they will be fairly subtle. This is in line with Vanguard’s earlier research on “dynamic spending” in retirement, which tries to establish a minimum income for fixed expenses and then layers on an additional amount for discretionary spending that can vary modestly based on market returns.
Over the long term, if VRIF ends up delivering a long-term total return of more than 4%, which is certainly possible, the rising distributions would even provide some inflation protection during retirement. On the flipside, if stock and bond returns are lower than expected for many years, even that modest 4% distribution might need to be reduced. Either way, VRIF is designed to avoid the dangerous practices of its competitors and seems likely to be sustainable during a long retirement.
In my final post in this series, we’ll put all of this theory into practice and consider the ways investors might use VRIF in their own portfolios—as well as some reasons to avoid it.