When the equity market has run up and we are not sure whether to stay invested, SWP may be used for a gradual withdrawal into a defensive asset class and get the benefit of exit cost averaging when the market is on the higher side.
When we withdraw a defined amount every month (or some other interval) from a mutual fund scheme as a standing instruction, it is referred to as systematic withdrawal plan (SWP). In a way it is the reverse of SIP; while investments are done through a systematic investment plan, redemptions are done through SWP. We will discuss here how it can be used by you vis-à-vis lump-sum redemptions.
Regular cash flow
When there is a requirement of a regular cash flow, say a defined amount every month, from a portfolio of MF investments, the common solution is to opt for dividend option in a fund that has a history of monthly pay-out—MIPs, Arbitrage Funds, Short Term Bond Fund, etc. The question arises when the amount of expected dividend does not match the cash flow requirement per month. In such a situation, the solution is to do a SWP.
To be noted, some investors believe that capital should not be used for regular expenses. However, if you require that money for your day-to-day expenses, it was anyway not an investible surplus and there is no issue in withdrawing it for your requirements. To look at it from a different perspective, for the period it was invested, you earned the returns and then withdrew it.
Funding retirement
SWP is typically used by retired people for their cash flow purposes. The estimated amount of expenses per month is put in the form of SWP. The SWP amount per month is consumed and the remaining corpus continues to earn the fund returns, which provides the sustenance for future.
Let us take an example. Let us say a 60-year-old retired gentleman has a corpus of Rs 1 crore in mutual funds and requires Rs 70,000 per month for his expenses. He does an SWP of Rs 70,000 per month. Apparently, at a withdrawal rate of Rs 8.4 lakh per year, his kitty would last for approximately 12 years and he may outlive his savings.
However, the remaining corpus continues to earn and the longevity of his corpus is extended to that extent. Building the cash flows in an Excel, assuming a rate of return of 8% pre-tax and post-tax return of 30%, i.e., net return of 5.6%, the corpus lasts for 20 years. This is conservative; there is tax efficiency in debt funds for a holding period of three years and a holding period of one year for equity funds.
Taking a net return of 7% for the purpose of our illustration, post the tax efficiency, the corpus lasts for 26 years, adequate for the investor in our example. The SWP amount in our example, i.e., Rs 70,000 per month, may be a combination of dividend and SWP. Dividends in Arbitrage Funds are tax-free, hence for the first one year, this may be used for generating tax efficiency. For debt funds like MIP or Short Term Bond, for a holding period of more than three years in the growth option, the amount withdrawn in a year will get indexation benefit.
Building defensive assets
There may be another use of SWP, apart from the post-retirement sustenance discussed above. When a market, typically equity market, has run up and we are not sure whether to stay invested, SWP may be used for a gradual withdrawal into a defensive asset class. Normally, market based triggers are used for this purpose. However, SWP also may be considered for this purpose. If SIP gives you the benefit of cost averaging while entering a fund when the market level is on the lower side, SWP would impart the benefit of exit cost averaging when the market is on the higher side. You may like to re-allocate a part of your portfolio to make it less prone to volatility in a phased manner.