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Every media outlet and offline channel from bank relationship managers and distributors, print, television, video (YouTube) and social media (X, Instagram, Facebook and LinkedIn) is now full of how starting an SWP from your mutual fund corpus will help you have a comfortable lifestyle in retirement.
All of these are standing instructions that get executed as per a schedule you specify:
Systematic Investment Plan (SIP): Money from a bank account is invested into a mutual fund, typically once a month
Systematic Transfer Plan (SIP): Units from a mutual fund are redeemed to invest in another mutual fund of the same AMC
Systematic Withdrawal Plan (SWP): This is the reverse of the SIP. You sell the units from a mutual fund to send money to a bank account
Why is there a push towards SWP in retirement?
The mutual fund industry, and similarly the stock advisory business, makes money when distributors and wealth managers manage more and more of their clients’ money via commissions. This is the just start SIP narrative which goes something like this:
Start an SIP today. You will then have enough money for financial freedom, a comfortable retirement and everything else.
Automatically, the next step of the advice is to answer the question of what to do once the crores of corpus are reached and the time for withdrawal starts. An SWP which is a convenient instruction to your mutual fund to regularly sell your units and give you money in your bank account becomes the obvious next step:
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Why is the just start SWP advice generally dangerous?
In real life, stock markets do not behave as simply as implied by the “Start SWP when retired” mantra which implicitly assumes that the stock market does this:
But the actual stock market returns look like this:
Here the average return is 17% of the Nifty 50 index with dividends reinvested, but never in this period the return was that average value. Here lies the problem. If you withdraw too much when the markets are down, especially at the beginning of retirement when the portfolio is small, then you will likely never recover. This is the concept of Sequence of Return Risk (SRR).
How SWP in retirement is bad advice due to the sequence of return risk?
Let’s take the case of a hypothetical retiree who gets the same returns as in the image above but in the worst possible order from the beginning of retirement:
Starting a SWP in such a market condition will lead to running out of money around halfway into retirement.
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We will now look at the opposite extreme case with the best returns happening in the beginning of retirement like this:
This case leaves a substantial inheritance to the heirs since there is now more than enough money even after the required withdrawals.
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Therefore, since actual life will be between these two opposite extremes, and will not be known in advance, it comes down to how much you are planning to withdraw in retirement.
SWR = the percentage of your portfolio that you withdraw in Year 1 of retirement and then increase that amount by inflation every year
The concept of Safe Withdrawal Rate (SWR) is used to put numbers around the percentage of the portfolio to be withdrawn in retirement every year.
When is the starting SWP for retirement not a lie and can actually work?
“nastiest, hardest problem in finance.” - William Sharpe, Nobel Prize winner, regarding the withdrawal stage of retirement
Therefore, it all comes down to the amount you are planning to withdraw every year. There are already a lot of assumptions in a retiree’s portfolio namely:
returns from equity, debt, gold and real estate
inflation over the next few decades
lifestyle expenses like travel and housing
medical expenses including geriatric care
increasing taxation on capital gains
longevity or the chance of running out of money by living too long
In such cases, high withdrawal rates or SWRs, implied by simplistic versions of the “just start SWP” advice is dangerous. We show some simulation results below, given that Indian equity market data starts from only 1979 after the launch of the SENSEX as explained in detail here: What happens if you do an SWP from an index fund in retirement?
We ran 1,000 such simulations for each of the SWRs (1-5%) and calculated the number of cases where there is a non-zero portfolio value after 30 years with a starting portfolio value of one crore.
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Here the “Nearly failed” case is equal to an ending value less than or equal to one-fourth of the starting value. Since the starting portfolio is ₹1 crore, any ending value less than ₹25 lakhs is a near-miss. At 7% inflation, this ₹25 lakhs has lost its purchasing power to just ₹3.2 lakhs in 30 years and will, depending on the SWR, pay for only a few months to a year of retirement expense in the 31st year.
The conclusion is quite clear:
the higher the starting corpus i.e. lower the SWR, the higher the chance of completing retirement
Below 3.5% SWR, the chance of finishing retirement exceeds 80% or 4 times out of 5
At 5% SWR or with only 20x expenses as retirement corpus, there 3 times out of 10 chances of failure by running out of money
Therefore, if your advisor is projecting or implying a withdrawal rate of more than the numbers in the chart above, then you need another source of advice.
What is the right way to implement SWP in retirement?
The first and foremost thing to keep in mind for retirement is that while you will have fixed and regular expenses in retirement, e.g. groceries and utilities, a lot of the big-ticket expenses like travel and lifestyle expenses will come at irregular intervals. Therefore, the retirement portfolio will not actually need to give you a replacement for your fixed salary income.
To understand how to construct a retirement portfolio in the right way:
We use the Arthgyaan Goal-based investing calculator to formulate the investment model with all the above assumptions and goals. There is a link to download a pre-filled copy of the Google sheet via the button below.
Important: You must be logged into your Google Account on a laptop/desktop (and not on a phone) to access the sheet.
Once you get your sheet, you can access video tutorials in the howto tab.
The concept of the 3-bucket retirement portfolio creates three risk-based asset pools or buckets out of the retirement portfolio:
Bucket 1: cash for short-term expenses (3-5 years) and emergency fund (12 months of expenses)
Bucket 2: debt assets for portfolio stability and income
Bucket 3: inflation-beating assets like equity MF and direct equity stocks
Instead of regular SWP-like withdrawals, the bucket portfolio moves money from the risky buckets when markets are performing well, via rebalancing, while deferring forced withdrawals from risky assets during bad patches in the market.
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This post titled The lie of enjoying financial freedom via SWP from mutual funds first appeared on 10 Dec 2024 at https://arthgyaan.com
