During a discussion, a friend mentioned that he was looking for a regular income and wanted to set up a Systematic Withdrawal Plan (SWP) to generate such income.
He asked me the equity fund (from his existing portfolio) where he should set up a SWP. I told him the approach could be risky. He couldn’t understand why. After all, he has been investing through SIP for many years with reasonable success.
I told him SWP is exactly the reverse of SIP. What works with SIP can go against you in case of a SWP.
SWP is different from a SIP
With SIPs, rupee cost averaging works in your favour i.e. you accumulate more units when the markets are down and less units when the markets are up. Hence, market volatility can be your friend in such a case (if you are investing for long term).
Read: Myths surrounding SIP
With SWPs, rupee cost averaging works in reverse. You sell more when the markets are down and sell less when the markets are up. This way, your portfolio can deplete much faster than expected.
Wouldn’t you want to sell more when the market is high and buy more when the markets are low? With SWP, exactly the reverse happens.
Let’s try to understand with the help of an example.
Suppose you invested Rs 1.2 lacs in a Nifty index fund (or ETF) on March 1, 2015 that replicates Nifty performance exactly. NAV of the fund is say Nifty Value/100. So, if the Nifty is 8000, NAV of the fund will be Rs 80 per units.
Your intent is to withdraw Rs 10,000 per month from this corpus for the next 12 months (on 1st of each month from April 2015 till March 2016). With Rs 1.2 lacs at your disposal for requirement of Rs 10,000 per month for 12 month, you can even do this at 0% return. Even if you keep this amount in savings bank account, you will have some change left after drawing 12 installments.
To sum up, the cash position is quite comfortable.
In the example, if the markets were closed on a particular day, I have taken NAV for the next working day. I have not considered the impact of exit load and capital gains tax.
Let’s see how you would have fared.
On March 2, 2015, Nifty was at 8956. NAV would be Rs 89.56. Hence, you will get 1,339.8 units for your investment of Rs 1.2 lacs.
Your corpus didn’t even last for 12 months. You corpus was over within 11 months. Had you kept this corpus in a liquid funds with post tax return of 5%, you would have easily withdrawn 12 installments of Rs 10,000 and still be left with little over Rs 3,500.
Who was the culprit?
Market volatility and your luck. And you can’t control either.
You started on a bad note. Your corpus went down almost 4% before you made even your first withdrawal. Within two months, even though you had withdrawn only Rs 20,000, your corpus was down by already ~Rs 28,000.
In a decumulation portfolio (like in this example), sequence of returns is also quite important. If you get a bad sequence of returns to begin with, it may be difficult to recover (even if you get good returns later on). If you are planning to generate income using SWP (from an equity fund) during retirement, do consider this aspect.
The reason is with poor set of initial returns, your portfolio depletes quite quickly.
If you start with Rs 100 and lose 20% on it, you need to make 25% on the remaining Rs 80 just to break even. So, you lost 20% but you need to make 25%. Add to it regular withdrawals from depleting corpus and you can how odds get stacked against you.
At the beginning, you had Rs 1.2 lacs for 12 months. And the situation was comfortable.
At the end of 2 months, you have ~ Rs 92,000 for 10 months. Not so easy now.
You can notice how you have to redeem more units to maintain level of income as the market goes down.
Ideally, you would want to do the reverse. You would want to sell less units when the markets are down and more units when the markets are up.
If the markets had remained flat during the period, you would have redeemed 111.64 units per month. In reality, you had to redeem much more.
I chose the period to suit my argument
Yes, I did. But it does not change my conclusion.
You don’t know upfront how the markets will behave in the next 12 months.
It is quite possible markets would have done well during the period. In such a case, not only would your corpus have lasted 12 months, but you would have also some excess at the period of withdrawal period.
However, when you plan, you do not only consider the optimistic scenario. It is no planning then, it is hope.
You have to be prepared for adverse events.
What should you do?
I am not against Systematic Withdrawal plans but you need to choose the right instrument for systematic withdrawals.
Do SWP from a less volatile debt fund (shorter duration). Move the requisite amount from equity to debt fund and set up a SWP from the debt fund.
You must keep tax considerations in mind. Tax treatment of debt funds becomes benign only after a holding period of 3 years. Additionally, you need to look at your marginal tax rate and decide when to switch from equity to debt.
In my opinion, you must switch from equity to debt fund (for SWP) much in advance. It is like any another goal. As the goal nears, move from equity to debt. Do not leave it for too late.