In this article, we cover the essentials of a mutual fund systematic withdrawal plan (SWP) in the format of an FAQ.
1: What is a Systematic Withdrawal Plan? The SWP is the opposite of a SIP. In a SIP, you invest a fixed amount each month (the most frequently used interval) and build a lump sum. In an SWP, you invest a lump sum and withdraw a fixed amount each month (typically) to be used as a source of income. The withdrawal is done so that the product of units redeemed times the current NAV equals the desired fixed amount.
2: Why were SWPs created? Anything that the AMCs do is primarily for their benefit. With an SWP, the AMC (and their salesmen) earn a fee/commission on the lump sum invested, and this income reduces gradually with each SWP instalment. Unlike a SIP, where the fee/commission builds up gradually over time, the SWP provides instant profit and is more beneficial to the AMC considering the time value of money.
3: When should I use an SWP? Like a SIP, an SWP is unnecessary (the same goes for the STP, too!). If you want to invest in a mutual fund each month, do so manually on any day of the month that is convenient for you.
If you want to withdraw from a mutual fund, do so whenever you like! There are no extra benefits of a SIP or an STP. Not getting tied down to an SIP allows you to invest as much as possible each month and vary the investment amount depending on your needs. Similarly, not using an SWP allows you to redeem whenever you want.
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4: Which type of funds can be used for SWP?
The SWP amount for any month = Current NAV x number of units.
If the NAV on the date of redemption is low, more units will be redeemed, and the investment will deplete faster. If the downward trend continues, the entire corpus could be exhausted sooner than anticipated.
Therefore, the simple thumb rule is never to set up a SWP from a fund in which the NAV is volatile (e.g. equity funds, so-called balanced advantage funds, aggressive hybrid funds, etc., are to be avoided).
Many backtested illustrations with equity funds, aggressive hybrid funds, and balanced advantage funds (ignoring that investment mandates keep changing) claim that the SWP worked even during the worst sequence of returns. This is laced with hindsight bias because we know when the market recovered and did not factor in the journey when the corpus depleted rapidly. It can be quite stressful in real-time as the future is uncertain, and we may not have enough corpus to take on such a risk.
The counter to this argument is to “set up a small SWP withdrawal (from a volatile fund)”. This reduces the risk of depletion and its usefulness. If such a SWP will only cover a small portion of expenses, we might let the money grow and occasionally withdraw from it manually for discretionary expenses.
We recommend using only liquid, overnight, and money market funds for regular withdrawals.
Those with a higher risk appetite (meaning more cash to burn) may consider ultra short-term or arbitrage funds. Those with a higher risk appetite may use Conservative hybrid funds or other long-term debt funds.
5: What precautions are necessary before setting up an SWP?
As mentioned above, the SWP is incorrectly recommended as a way to get a regular income after retirement from volatile mutual funds. Senior citizens with limited capital market experience in their youth and/or limited funds to work with should not be enticed by the advertised claims of “income with growth”.
Trying to maximise retirement income with less than an ideal corpus is an extremely difficult problem in finance, and an SWP from a volatile mutual fund can result in an irredeemable disaster.
Beware of SWP backtests with balanced advantage or any other mutual fund. The “past performance does not reflect the future performance” disclaimer applies!
6: Can I use a SWP as a retirement bucket strategy?
Yes, but as mentioned above, it will have to be from a liquid fund for either the main income (in case of no other pension source) or for handling discretionary expenses. For example, I am 30 and wish to retire by 50, how should I plan my investments?