What is a Systematic Withdrawal Plan?
Systematic Withdrawal Plan is used to redeem your investment from a mutual fund scheme in a phased manner. Unlike lump-sum withdrawals, SWP enables you to withdraw money in installments. It can be viewed as the opposite of SIP. In SIP, you channelize your bank account savings into the preferred mutual fund scheme. Whereas in SWP, you channelize your investments from the scheme to the savings bank account. It is one of the strategies to deal with market fluctuations.
With the Systematic Withdrawal Plan, you can customize the cash flow as per your requirement. You can choose to either withdraw just the capital gains on your investment or a fixed amount. This way you will not only have your money still invested in the scheme, but you will also be able to access regular income and returns. The money that you withdraw can be used to reinvest in some other fund or can be retained by you in the form of cash.
Types of SWP –
There are 2 types of SWP
- Fixed SWP – where a fixed sum is withdrawn from the mutual fund on the set date, irrespective of the fund’s performance, hence, this method can erode your capital when the fund has not performed very well.
- Appreciation SWP – where only the gains (appreciation) that have happened in the scheme are redeemed on the set SWP date. Avoiding erosion of capital but can lead to erratic numbers each month.
How does SWP work?
An SWP gives surety of a stable payout to the investors at predetermined intervals. This implies that at some stage the investments will be completely repaid along with the gains in the hand of a mutual fund investor.
Hence, an investor is assured of getting a fixed amount at his/her pre-determined frequency through an SWP.
- If the fund’s performance is good, the SWP will last longer.
- If the performance is poor, it’ll finish sooner.
- If your annual withdrawal is less than what the fund generates every year, you can continue earning from this mutual fund forever.
Why do I need to set up an SWP?
- Manage the market risk – SWP like SIP helps you to reduce your market volatility risk by averaging your return over a period of time. If you withdraw/deposit lumpsum amount at a given point of time, you are bearing the risk of markets going up or down after that. Through SWP, you are distributing it over a period of time. Where the markets are up, you make higher gains and vice versa. SWP is automatically doing that for you, you do not have to keep a continuous tab on the market.
Just as Systematic Investment Plans (SIP) avoid market risk at the time of investment, SWPs lower market risk at the time of redemption.
- Regular Income for your family on retirement or otherwise – For retirees with huge corpus and need for regular income, SWP is a great option. Through this, the retirees can invest in mutual funds and set up SWP equivalent to the amount they need each month for their regular expenses.
- The second stream of income – For someone who wants additional income each month and has a large corpus that they have invested. SWP can work as a good option.
- Reduced Taxation as compared to the dividend option – the redemption from SWP is taxable based on the mutual fund – debt or equity. Each SWP gains are taxable. However, even the dividends that you shall receive from the dividend option mutual funds are taxable. Hence, it is important to consider the tax impact before taking an investment decision.
Spreading investment over the right time period is the key. The STP can be done over a time period of three to four months or across several years. Investors are frequently at a loss as to how many monthly installments to break up the investments into. Since there is no underlying inflow as in the case of a salary that feeds a SIP, this is entirely at the discretion of the investor.
Consider the example of someone who came into R20 lakh in December 2007 and then invested it all in an equity fund. In four months, the money would be reduced to less than R10 lakh. In some cases, funds could have gone down to R5 or 6 lakh. After taking such a big hit, a person may never invest again. It will take about six years for him to break even. However, suppose this investor had invested gradually over 12 months. In that case, only about a tenth of the money would lose a lot of its value. Overall, averaging over a year, the acquisition cost would be such that the investment would hardly ever be in a loss. Of course, I’ve taken an extreme example to illustrate the concept, one that takes the investor from an all-time high peak to a low point. You could have started a little earlier, say in 2006 and then spread the investment over a longer period.
However, if you actually look back at the markets over the last decade, you will realize that while an STP generally helps one avoid a market peak and average costs, they are not a foolproof device.
Equity is equity and there’s no way of doing away all risks. However, based on what has happened over the last two decades in India, stretching an investment over two to three years is likely to capture enough of a market cycle to significantly reduce risk.
An Example of SWP
You have a corpus of INR 3 lakhs that you have decided to invest in a debt mutual fund and set up SWP of INR 10,000 each month. SWP of INR 10,000 will be redeemed from the mutual fund each month on the set date and that money will be transferred to your bank account. After the redemption, the balance amount in the mutual fund will be invested to grow.
Wealth Cafe Actionable – SWP works better when a person has invested and accumulated a significant sum (with respect to the withdrawal one is seeking). In a small investment, if the return generated is less than the regular payouts, it will fast erode capital. Also, when the markets are doing good, SWP will erode your capital and your invested amount will be redeemed. Balanced Funds are a good option to invest in while doing an SWP as it is taxed like a debt mutual fund but has 35% equity to help the corpus grow faster.