What Is a Targeted-Distribution Fund?
The term targeted-distribution fund refers to a specialized mutual fundor exchange-traded fund (ETF) that distributesregular payments of income or capital gains to its investors. As suggested by the name, this type of fund focuses on distributions rather than contributions, usually with a specific retirement date in mind. This makes them suitable for individuals who are closer to retirement age. Targeted-distribution funds are designed as long-term income streams for retirees. They became popular as the baby boom generation has aged into retirement and as employer-sponsored defined benefit pension plans disappear.
Key Takeaways
- A targeted-distribution fund is a mutual or exchange-traded fund geared toward individuals who have a specific retirement date in mind.
- Funds pay investors a steady stream of income through dividends, interest, and return of principal.
- You can invest in a target-distribution fund through an employer-sponsored plan or on your own through a brokerage company.
- These funds provide relatively predictable distributions with low expense ratios but don't have the same potential for market gains as other funds.
- Although they are generally considered tax-efficient, target-distribution funds may incur capital gains taxes based on when and how the distributions are taken.
Understanding a Targeted-Distribution Fund
Retirement is the time when individuals permanently leave the workforce. Rather than a paycheck, retired individuals receive Social Security benefits (as long as they qualify), pensions (if their employer provides one), and any other retirement income. This revenue stream comes to those who plan through accounts, such as 401(k)s and individual retirement accounts (IRAs), which pay distributions to retirees.
Many retirement accounts require investors to set aside money in different investment vehicles, such as mutual funds, ETFs, and targeted-distribution funds. Rather than focusing on the acquisition or accumulation of assets, these funds pay attention to the distributions that are made to investors. As such, the strategy of targeted funds considers a specific retirement date by which investors expect to receive distributions.
Also known as open-end managed-payout funds or target retirement funds. these funds provide capital gains- or income-based distributions to investors. One important point to note, though is that not all targeted-distribution funds promise a specific payment amount or a minimum payout amount. Payments may vary depending on the current market performance of the fund.
A fund may state its principal retention strategy or inflation-adjusted payout formula, but if the portfolio performance does not result in sufficient returns, the fund managers are usually not obligated to make payouts or protect principal investments.
Some funds are designed to protect the principal investment while paying out dividends and interest income, while others deplete the principal investment to make the promised payments as necessary.
Advantages and Disadvantages of a Targeted-Distribution Fund
There are some obvious advantages and disadvantages to investing in a targeted-distribution fund. We've listed some of the most common ones below.
Advantages
Targeted-distribution funds don't provide set payouts the same way annuities do. But they do pay as close to the predicted amount as possible. This is a key point for investors who want a steady and predictable stream of income.
These funds are allowed to grow over time based on their underlying investments. By the time the investor is ready to start taking distributions from the fund, it has been rebalanced to the point of being both liquid and relatively stable.
Another benefit of these funds is the ease of investment. This means they are typically as simple as purchasing a single ETF, sitting back, and letting the fund do its thing until you reach the target date. Like many ETFs and mutual funds, these funds also come with low expense ratios and have tools in place to minimize the risk to investors.
Disadvantages
These funds do not guarantee that the payout will remain constant, and are subject to human error. The pressure is high for fund managers to deliver their advertised distribution rate, and can sometimes make risky investment decisions in order to achieve those rates.
Not everyone close to retirement wants a portfolio that is so risk-averse. If you chose a target fund with a distribution date of, for example, 2050, but the market experienced a sharp rebound in equities from 2047 to 2050, the fund's lack of equity exposure could mean missing out on some gains in the market. Investors who simply pick a targeted-distribution fund and don't venture into other securities limit their exposure to volatility, thereby limiting their upside potential as well.
Pros
One of the easiest retirement tools in which to invest
Predictable distributions
Low expense ratios
Built-in risk exposure safeguards
Cons
Lack of potential broad market gains near target date
Some funds pay distributions from principal balance when they underperform
How to Invest in a Targeted-Distribution Fund
It isn't difficult to invest in targeted-distribution funds, especially if you already established a retirement account like a 401(k). Many employers offer them within their 401(k) plans with target dates such as 2030, 2035, 2040, and more. Whichever target date you choose depends on the age at which you start investing in the fund.
Investors considering a targeted-distribution fund would only need to purchase the fund through their broker. Some of the more popular brokerage companies are Vanguard, Fidelity, Charles Schwab, T. Rowe Price, and State Street. For example:
- Vanguard's Target Retirement Income Fund is designed for investors who have already retired. Most of its assets are invested in Vanguard bond funds, with the remainder scattered across a number of stock index funds and even an international stock index. A low bond-to-equities ratio keeps the fund stable and fairly predictable.
- The Strategy Shares Nasdaq 7HANDL Index ETF (HNDL) claims to be the first targeted distribution ETF. The bulk of its investments is in bond ETFs with more than 15% in large-cap stock ETFs.
- Fidelity offers investors its Freedom 2045 fund. Its objective is to provide investors with high returns until the target year of 2045 by focusing primarily on current income before capital appreciation. Investments range from U.S. and international equities, as well as bond funds and short-term funds.
- T. Rowe Price Retirement 2050 Fundfocuses on capital growth and income by investing in bond and equity funds. The fund uses a glide path to make its asset allocation more conservative as it approaches the target date.
If you don't have a 401(k) or if you don't find the options within your employer-sponsored plan appealing, you can always purchase a target-distribution fund through either a retirement account such as an IRA or in a taxable account.
Targeted-Distribution Funds and Taxes
Choosing the right retirement accounts and related investments is crucial for your retirement planning strategy. After all, you want to end up with as much bang for your buck as possible. But it's also important to keep in mind the tax implications of the investments you hold.
Most target-date funds are considered tax-efficient investments because of the way they use index funds. Index funds are generally passively managed, which means very little changes in the way they are traded over their lifetime. But buying and selling shares in these funds may trigger taxable events. Furthermore, distributions may be taxed on long-term or short-term capital gains based on how and when you take the distributions.
For example, when the target date arrives, you may decide to sell what you own outright. Perhaps you decided the fund wasn't right for you or you needed the capital. In this scenario, as long as the fund held the underlying shares longer than a year, you would pay the long-term capital gains tax. If, on the other hand, they were held for a shorter period, you would pay the short-term capital gains tax, which is much higher. The Internal Revenue Service (IRS) taxes short-term gains as ordinary income.
Some other considerations include foreign tax credits for funds that have international equities in their portfolios. Capital gains (or losses) may also be triggered by the fund's glide path, which is used to reallocate a portfolio's asset allocation toward conservative balance as it gets closer to its target date.
The rules for withdrawals before retirement apply to targeted-distribution fund(s) the same way they do for any other retirement vehicle. You are responsible for an early withdrawal penalty of 10% if you take money from your account before the age of 59½ plus applicable taxes on the distributions.
Distributions vs. Dividends
Funds pay investors distributions and dividends, which can often confuse many investors, so it's important to note the distinction between the two, as both have different tax implications for investors.
A distribution is a disbursem*nt of cash from a fund or account, such as a retirement account. The IRS requires retirees to take required minimum distributions(RMDs) from certain accounts, such as employer-sponsored plans and traditional IRAs. These distributions, which are taken as income, are calculated by dividing the previous year'sfair market value (FMV) of the account by the life expectancy.
Dividends, on the other hand, are the distribution of a fund's earnings. They are disbursed to shareholders at regular intervals. Many of the offered funds and target-date ETFs pay dividends to their shareholders. However, the type of dividend determines your tax responsibility.
Targeted-Distribution Funds vs. Pension Plans
The private sector began to abandon defined benefit pensions in the 1970s. The targeted-distribution plan is one of many investment choices invented to replace the private-sector pension that once provided a degree of security for American retirees. The tax-deferred company-sponsored 401(k) retirement fund was introduced in 1978, and employers were quick to switch to this less costly way to offer an employee benefit.
In 1975, the U.S. Department of Labor showed that 88% of private-sector workers were covered under defined benefit plans. By 2021, only 51% of workers took part even though 68% of the private-sector workforce had access to retirement plans. The situation is very different for government workers. In 1975, 98% of public-sector employees were covered by a pension. In 2021, 82% of private-sector workers participated.
Many workers, though, have neither option available to them. More than one-third of workers don't have access to a workplace retirement account. Many analysts have long anticipated a crisis for retirees in the coming years, especially as underfunded defined-benefit pensions struggle to remain solvent.
Frequently Asked Questions
How Are Fund Distributions Taxed?
The taxation of your funds depends on a few factors. If you held the fund for less than 12 months and you realize a gain, you incur a short-term capital gain. This is taxed as ordinary income that you must report to the IRS on your annual tax return, which could put you into a higher tax bracket. Fund shares that are held for more than a year are taxed as long-term capital gains at rates of 0%, 15%, or 20% based on your taxable income.
How Are Mutual Fund Distributions Paid?
Mutual fund distributions can be paid in cash or through a reinvestment. Investors who choose to receive cash are paid on the record date, which is the date before the distribution date. Funds are paid based on the total number of units or shares investors hold. If an investor chooses not to take cash, they may choose to reinvest the distribution into the fund by purchasing a certain number of shares.
Can I Withdraw Money From a Mutual Fund Without a Penalty?
You may be able to withdraw money from your mutual fund account without incurring a penalty provided there are no early withdrawal conditions placed by the fund company. For instance, if you make a withdrawal from a fund held in a retirement account, you will incur early withdrawal penalties and taxes.
