Pay attention to a few key factors that underscore the stability of a payout fund's distributions. By Eleanor Laise, Senior Editor September 2, 2011 EDITOR'S NOTE: This article was originally published in the July 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.Mutual funds offering attractive periodic payouts seem hard to resist in this period of paltry interest rates. But income-oriented investors considering such funds need to take a close look under the hood to determine if that reliable income engine is about to run out of gas. SEE ALSO: Special Report on Investing in Volatile Markets Many funds purporting to offer steady distributions sputtered amid rocky markets in recent years, either slicing their payouts or abandoning them. Some products were aimed squarely at people in or near retirement and pitched as tools to help replace salary income. Advertisement All mutual funds are required to distribute income and capital gains to shareholders at least once a year. Investors often reinvest these distributions. But payout-oriented funds are structured to provide investors with a predictable stream of income. Loss of income isn't the only potential fallout from distribution disruptions. In closed-end funds, which trade throughout the day on exchanges and often appeal to income-hungry investors, a payout reduction can mean a sharp drop in the fund's share price as shareholders dump shares that no longer offer an attractive yield. In such cases, a distribution cut can be "a dangerous situation" for shareholders, says Cecilia Gondor, executive vice-president at investment advisory firm Thomas J. Herzfeld Advisors. While investors can't always predict distribution cuts, they can pay attention to a few key factors that underscore the stability -- or fragility -- of a fund's distributions. That involves considering the investment strategy and total returns that are backing up the yield. "Making sure you understand the components of the distribution, rather than just the distribution on its face, is important," says Cara Esser, an analyst at investment-research firm Morningstar. What's the source? Funds offering regular distributions often cover payouts with income from their investments or capital gains on the sale of fund holdings. But if those sources aren't sufficient to fund payouts, the funds may simply return investors' own money in the form of a distribution. Such a "return of capital" can whittle away at fund assets, leaving a smaller asset base to generate growth and fund future distributions. Advertisement Consider Baron Retirement Income fund, which was designed to pay annual payouts of at least 4% of net assets per share. From its launch in mid 2008 through the end of that year, all of the 40-cent-per-share payout was a return of capital. In 2009, distributions fell to 25 cents per share, and return of capital accounted for roughly half of the payout. The following year, the fund changed its name to Baron Focused Growth and ended the payout plan. Before you invest, check fund annual reports to see what portion of distributions is generated by investment gains and income, and what portion comes from return of capital. A brief use of return of capital isn't necessarily grounds for rejecting a fund. But a fund that consistently hands back investors' principal may be headed for unpleasant payout surprises. Smoothing the ride. Some payout-oriented funds have systems for reducing the volatility of their distributions, even during a bumpy market. The three Vanguard Managed Payout funds, for example, invest in a mix of stocks, bonds, commodities and other assets. They are designed to make monthly distributions while preserving or increasing the value of shareholders' investments over the long haul. Instead of distributing a set percentage of net assets, the funds' payout formula is based on the past three years' worth of performance. That mechanism "is there to smooth out the ups and downs" in the market, says John Ameriks, head of investment counseling and research at Vanguard. Because the Vanguard funds were launched in the brutal market of 2008, their initial payouts consisted of return of capital, and distributions were trimmed back in 2009 and 2010. Last year most of the payouts came from income and capital gains, and this year the funds' payouts increased by roughly 1% to 2%. Advertisement Inflated share prices. Assessing the health of distributions is particularly important for investors considering closed-end funds, which have a fixed number of shares that typically trade on an exchange. Funds offering juicy payouts often trade at a hefty premium to their net asset value (NAV), meaning investors are paying more than the value of the fund's holdings. A distribution cut means that "the fund is vulnerable to losing that premium and going to a discount in a very short period of time," says Herzfeld Advisors' Gondor. That would mean a sharp drop in the share price, and investors selling the shares would receive less than the value of the underlying fund holdings. In some cases, investors are paying inflated prices just to have their money handed back to them over time. The Cornerstone Total Return fund, for example, as of late August, had a distribution rate of more than 16% and traded at a nearly 50% premium to the value of its holdings. What's more, almost all of the fund's distributions in recent years consisted of return of capital. "This is a pattern that over time is going to be destructive to shareholders," says Morningstar's Esser. Cornerstone declined to comment on the fund's distributions. To assess closed-end fund distributions, type the name or ticker symbol in the quote box at Morningstar.com and click the "distribution" tab. You'll see what portion of distributions come from income, capital gains and return of capital. Also check the NAV performance by clicking the "performance" tab. If you see a large return of capital and a declining NAV, the fund is likely not earning enough to cover its distributions. Advertisement Passing the smell test. If a closed-end fund's distribution rate seems out of line with long-term expected total returns for its investment strategy, those payouts may not be sustainable. Take Eaton Vance Tax-Managed Global Diversified Equity Income fund, which invests in stocks and sells options to generate additional income. As of October 2009 its NAV distribution rate was roughly 15%, so investors were getting about 15 cents for every dollar of fund assets. "It would be nice" if such a strategy could consistently produce 15% returns, says Mariana Bush, closed-end fund analyst at Wells Fargo Advisors. But, she says, is it very realistic? "I would say it's not an extremely high likelihood." Indeed, the fund slashed distributions by nearly 20% in early 2010 and another 26% early this year. Jonathan Isaac, head of product management at Eaton Vance, acknowledges that the distribution rate was high, but that rosier expectations for stock market returns predominated when that higher distribution rate was set. Those expectations, he says, were "to some extent shattered by what happened in 2008 and early 2009."