My 40-year-old friend used to be less anxious about his retirement. He and his wife have been saving regularly for their retirement. However, due to a lack of financial planning, they were unsure if they are on track to meet their goal.
They were investing, but somewhat randomly, as and when they had some savings. Whether they would retire peacefully without compromising on their lifestyle remained a big question mark.
But as one would have it, high inflation caught them unawares. Their household budget is now up by 10%, and they were finding it hard to keep their savings rate at the same level as a year ago.
They had intended to invest in an apartment to create rental cash flow. That goal now seemed difficult as they realised they would fall short of the needed amount, and the rising interest rates made taking a loan costly.
That’s when a financial advisor suggested doing a Systematic Withdrawal Plan (SWP) on mutual funds instead of seeking rental income from buying a second home.
The couple had saved a sizeable chunk of money (Rs 50 lakh). SWP was touted as a solution to provide regular extra income and tackle high inflation in the economy while they continued to save for retirement. Does it work?
What is an SWP?
SWP is an investment tool whereby you periodically withdraw money from your fund. The frequency varies based on your preference – monthly, quarterly, semi-annual and annual.
Unlike stock dividends, here you receive income regardless of market performance. And since you make only piecemeal withdrawals, the balance units in the fund continue to grow and earn returns for you.
It is also smarter since you follow a disciplined approach to investing without resorting to short-termism. Not least, there are tax efficiencies, especially for long-term investors.
Supposing my friend needs a monthly income of Rs 25,000 (Rs 3 lakh annually) to supplement his existing household income for a period of five years. In that case, they must invest Rs 50 lakh, assuming an annual withdrawal rate of 6%.
The end result would vary based on the asset allocation of the fund. For the sake of comparison, let’s consider three investment scenarios – SWP in equity, balanced and a debt fund (of a leading mutual fund house) for a period of five years. In all three cases, Rs 15 lakh worth of money would be withdrawn over the period of five years.
Scenario one (Equity)
Investing Rs 50 lakh in an equity fund five years back would have given a CAGR return of 11.8%. Despite regular redemption of units, appreciation of NAV resulted in the end portfolio value (Rs 66.8 lakh) becoming more than the originally invested amount.
Also, since long-term capital gains up to Rs 1 lakh is exempt from capital gains taxes for equity-oriented funds, investor pay a tax of just Rs 5,574 over the five-year period (see table). As a percentage of SWP amount, tax works out to just 0.4%.
Scenario two (hybrid)
In turn, investing in a hybrid fund would have seen relatively lesser return, and tax liabilities, than an equity fund (see table). Also, the portfolio value at the end of the five-year period would be slightly lesser (Rs 63.7 lakh).
Scenario three (debt)
By investing in a debt fund, not only are the returns halved as compared to that equity/hybrid funds but also the portfolio value is lesser by 28% than that of an equity fund. Furthermore, tax liabilities are the highest since tax rates are relatively higher for debt-oriented schemes (see table). Tax as a percentage of the SWP amount effectively works out to 1.9% in this case.
This is even though the fund makes a lesser capital gain of Rs 1.2 lakh than that of the equity fund (Rs 2.8 lakh) and hybrid fund (Rs 2.7 lakh).
Often investors work out a higher withdrawal rate of their corpus to take care of their additional spending. But, SWP is not an investment solution. Rather the focus should be on fixing a financial target for their critical goals – be it that of retirement or a child’s higher education and invest enough to get there by choosing the appropriate asset allocation.
Unless an asset allocation strategy is in place, the investment journey will remain uncertain and sloppy. And the above analysis proves that equity provides the best potential to beat inflation and create wealth among all the asset classes.
SWP is a good investment tool to plan your cashflows once you have built a corpus for your goal (say retirement). Don’t see it, however, as an entire solution in itself.