While hybrid mutual fund and annuity product solutions began gaining advisers’ and investors’ attention last year, such managed payout funds still have flaws. That’s according to a report from MarketWatch.

The biggest problem is that in down markets, many of these funds have to eat away at their principal in order to honor payment guarantees. As MarketWatch puts it, “They may be eating themselves alive.”

Vanguard’s Managed Payout Distribution Focus Fund, for instance, began using up capital only four months after launching, and when all is said and done for 2008, 77% of the fund’s distributions will have come from the fund’s principal. The story is somewhat better, but only marginally so, for the Vanguard Growth and Distribution Fund, which is eating up 71% of its principal, and the Vanguard Growth Focus Fund (63%).

The truth of the matter is, said Dan Wiener, editor of The Independent Adviser for Vanguard Investors, “These funds just haven’t been making money.”

But analysts cut Vanguard some slack in saying that the funds launched at a turbulent time for the market and that over time, their design might prove wise. The problem at the outset, however, is that the bear market is reducing the principal amount significantly, lowering future returns.

Charles Schwab believes it has gotten around the product design with its managed payout funds, which it debuted in March: Maximum Payout, Enhanced Payout and Moderate Payout. These funds don’t touch principal. Thus, their income streams fluctuate.

On the other hand, Fidelity’s Income Replacement fund line, which it launched in August 2007, are designed like target-date funds in reverse in that they gradually eliminate all of the money in the funds, plus gains, with payout percentages (not necessarily dollar amounts) increasing as the end target date approaches.

“It’s a solution that gives investors a peace of mind about income that will last a certain amount of time,” said Allan Telenko, a vice president and product manager at Fidelity.

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