Fidelity has a new retirement investment and income program called Income Replacement Funds. One of its objectives is to attract retiring employees who are ready to roll over the balances in their employer-sponsored retirement plans, such as the Thrift Savings Plan. The TSP, with more than $200 billion in assets, is a particularly attractive target for investment companies as federal employees retire and gain access to their accounts.

As a retiring or retired TSP participant, you need to be knowledgeable about the options available for meeting your retirement income needs. I have heard reports of misleading claims by major investment advisory and management firms that were clearly intended to convince TSP participants that they could expect to achieve superior investment and income performance by moving their money out of the TSP after retirement. This is not only an uncertain outcome, but given the TSP’s advantages, an unlikely one.

Fidelity’s marketing for its new program caught my eye because it seems to promise the best of all worlds – maintain ownership and control of your investment assets while maximizing retirement income and potentially growing your wealth. The marketing materials for these funds don’t really explain what they are or how they work, only that they’re designed to provide a steady stream of income from an amount of money you invest. So, I thought I’d take a closer look at the program and try to explain it in plain terms.

The program is actually a combination of two components: a series of targeted-maturity mutual funds and a schedule of automatic monthly withdrawals matched to the duration of each of the funds.

The mutual funds are similar to the TSP’s L Funds in that each fund is a combination of existing Fidelity mutual funds arranged in an allocation that Fidelity’s advisers deem appropriate for that fund’s particular time horizon. Fidelity offers 11 such “funds of funds” with maturity dates ranging from 2016 to 2036. The expense ratios – the share of your investment’s value Fidelity deducts each year for expenses – range from 0.54 percent to 0.65 percent. Not bad as mutual funds go, but about 13 times the cost for owning the TSP’s funds.

Like the L Funds, the asset allocation in each of the Fidelity funds will migrate to become more conservative as the maturity date approaches.

While you may purchase the Income Replacement Funds as a stand-alone investment, they are designed to be combined with Fidelity’s Smart Payment Program. This program sets up a schedule of percentages that increase over time and are applied to the balance in your account each year to determine the coming year’s income payments from the fun.

For example, if you invest $100,000 in the Fidelity Income Replacement 2036 Fund on Jan. 1, 2008, your monthly Smart Payments for 2008 will total 5.18 percent of your account’s $100,000 starting balance. For 2009, your income payments will be recalculated so that they total 5.27 percent of your account’s ending balance for 2008. This process continues, according to a schedule of annual Smart Payment percentages, until the fund’s maturity date is reached and any remaining balance is distributed to you.

Your income for each year will likely vary – it may be higher or lower than the previous year’s income, depending on the previous year’s investment results. While the percentage used to calculate your annual income payments goes up each year, the increase may not be enough to overcome a drop in your account’s balance corresponding to poor market performance.

While a professionally managed investment portfolio combined with systematic withdrawals may seem like an attractive strategy to many retirees, it is important to understand the realities and risks inherent in these programs. I can’t see where Fidelity’s program insulates you from any of the risks you’d bear in implementing a similar strategy in a TSP account. Buy an L Fund or implement an otherwise appropriate asset allocation strategy using the five TSP funds and request monthly distributions based on your life expectancy.

In either case, you won’t know in advance what your payment will be each year, and your investment might fail to support your needs or your expectations. The only clear advantage going in is offered by the TSP’s lower investment expenses.

I don’t mean to pick on Fidelity, especially since I think that it’s one of the better choices for investors without reliable counsel. I expect to see similar efforts to attract retirement assets from other companies, and as always, I encourage you to be skeptical in your assessment of these opportunities.

Written by Mike Miles
For the Federal Times
Publication November 5, 2007