Arun Kumar, Head of Research, FundsIndia.com, says “one has to build a two-bucket system. The first bucket is 85% of your portfolio. The second bucket will be 15% of your portfolio. Now, let us say you have Rs 100 as the portfolio from which you will have to build this monthly income solution. First, you put Rs 15 into a very safe short-term debt fund. This will be the buffer. In case something goes wrong, this is the bucket to take the money out but this is mostly from a safety perspective. The remaining 85% can be deployed in an aggressive hybrid fund which will have roughly 70% equity and 30% debt. A more conservative approach means one can have a product called Balanced Advantage Fund where equity allocations will generally move between 30% to 80% of the portfolio. ”
Systematic withdrawal plan is a very popular concept, but a lot of people are unaware about the nitty-gritties and when we deep dive into it, there are a lot of technicalities which get lost in the entire concept. So, let us understand a very basic concept” what is a systematic withdrawal plan and is it only something that is offered by mutual funds?
Let us assume you have mutual fund units and you need to withdraw a particular amount every month. Let us say you have Rs 10 lakh in a particular fund and you want to withdraw Rs 5,000 every month. Now, you will have to manually open your app, do the redemption and then take it out. Then, again, next month, you will have to remember to do that on the same day.
So, mutual funds said, hey, if you want to do it on a regular basis, we will let you automate it. Now, you can choose the date, you can choose the frequency, it can be weekly, it can be monthly. So, in essence, an SWP is just automating the process of taking money out of your mutual fund and whatever is the amount and frequency that gets defined by you.
The other way to think about it is exactly the opposite of an SIP, where you decide what to invest, when to invest and how long to invest and then that is automated so that you do not need to do it automatically. It is taken from your bank account and put into a mutual fund. This is just the opposite, every time money is taken out of the fund that you have chosen and it automatically gets deposited into your bank account.
Usually, the use case for this is that if you are retired or financially free and you want money from your portfolio to support you, you can use an SWP plan so that for whichever funds that you have chosen, every month without you having to manually do it, the amount automatically hits your bank account and so that is the broad use case for which SWPs are used. It is not a strategy, it is just a simple automating system. So, it is more of a convenience.
So, it is more of a convenience feature. Now, if you are an investor who might want to opt for SWP, maybe after a certain period of time in your life where you might want to have a regular income out of your investments, how can you go back and plan it accordingly? In order to get a certain amount of money every month, you should be having a certain amount of investable money which will also grow, along with you getting a regular income. So, how can one plan for it because that is the most difficult part?
As you rightly mentioned, the trade-off is between three factors. One is there is a particular amount that I require every month. Also, this amount will have to grow because there is inflation and I cannot have the same amount getting withdrawn every year because by next year, the inflation will be higher. I want this amount to also grow which is my second factor and the third part is that the entire portfolio that I have built, because I am withdrawing, I do not want to see it go into negative. I want that portfolio to grow also.
So, I have these three factors and obviously any factor which I overdo will have an impact on the other two factors. So, how do you create a trade-off between all three and ensure that you also end up getting the right amount that you want every month? The way to start off with this rough thumb rule would be that you should at least have 25 times your annual money requirement as your portfolio size to build a good monthly income kind of a solution. So, if you want Rs 1 lakh every month, then for an entire year you will require 12 lakhs. So, 25 times of that would roughly be close to 3 crores. So this is the first part.
Now, the second part is you obviously want this money to also grow, which means that this year I will take Rs 1 lakh every month, but next year assuming inflation at let us say 5%, you might want to take Rs 1,05,000 next year and post that again you want to increase it by 5%, so this is the second part.
The third part is you also want your original Rs 3 crore portfolio also to grow, say at 3%, 4%, 5% but you want some growth there, you do not want that to come down.
Now, how do we put it in place using mutual funds? A simple thumb rule would be to have a two-bucket system. The first bucket is 85% of your portfolio. The second bucket will be 15% of your portfolio. Now, let us say you have Rs 100 as the portfolio from which you will have to build this monthly income solution. First, you put Rs 15 into a very safe short-term debt fund. This will be your buffer, just in case something goes wrong this is the bucket that you will use to take the money out but this is mostly from a safety perspective.
The remaining 85% you can deploy in an aggressive hybrid fund which will have roughly 70% equity and 30% debt. Now, if you want to make it slightly more conservative, you can also use a product called Balanced Advantage Fund where your equity allocations will generally move between 30% to 80% of the portfolio.
So, the idea is Rs 85 goes into aggressive hybrid funds and Rs 15 goes into debt funds. Now, the next thing that you do is once you have set this up, then you go to the aggressive hybrid funds and then set up an SWP for every month. Now, this can be roughly totalling to 4% of your portfolio per year. So, you divide it by 12 and you will know the monthly amount to be set and then you set it up running. Now, obviously, this has an equity component.
The second part that you will have to do is that if there is a market for say more than 15%, you will have to stop the SWP from this particular Rs 85, which is your core portfolio and then do the SWP for the same amount from your debt portion which is safe. Then again, once the market recovers, you can shift the SWP back into your 85% the core aggressive hybrid portfolio. So, in this way, you can ensure that you get a regular income from your core portfolio. But in the case of a large market correction, you can also shift it to the safer debt portion.
The third thing that you will do is every year you will be increasing the SWP amount by 5%. So, overall, the idea would be to get 4% from your portfolio every year. This will increase it by 5% every year. 4% from your portfolio is the money that you will use for your requirement.
Second is you will also increase it by 5%. The third part is that you will also want your portfolio to grow. So, roughly 3% to 5% is a good number to look out for in this particular plan. The overall assumption is that at a portfolio level, you might try to attempt a 10% plus kind of return. This is how you can put in place a simple SWP system which can work over long periods of time.
But in order to have a withdrawal plan of 4-5% and annual increase of 5%, one also needs to come down to that particular figure that needs to be invested after a certain period of time. Also what about taxation because I think that is a very big positive for SWP?
Actually, there is no particular advantage because of an SWP because in essence, it is just a feature where you are withdrawing from a particular fund instead of doing it manually, which is automated. So, again, back to basics; let us say today, I decide to withdraw some money from an equity fund. So, the equity taxation will apply. In the case that we discussed where 85% goes into aggressive hybrid funds, it has equity taxation. Which means if you are taking out the money for the first one year, you will get a tax of 15%. But post one year, if it is less than 1 lakh, which is your capital gains, then you do not need to pay any tax. But once it crosses Rs 1 lakh, you will have to pay a 10% tax. So, based on your monthly income that SWP that you are taking out, you will know what the gains are and it will be a very small amount in terms of the tax impact would not be very high.
The remaining 15%, if it is a pure short-term debt fund, then you will incur debt taxation. In other words, it will be added to your salary and you will have to pay your tax slab. So, let’s say if you are on the higher tax slab and you want the equity taxation, then arbitrage funds can be a safer option. If you want to slightly increase risk on this portion – which is not advisable – but if you want it, you can also look at a very, very conservative equity savings fund, which will have probably 10-20% into equity and the remaining goes into arbitrage and debt.
So, the advantage is you will get equity taxation. This can also be explored. If you are okay with a little more volatility on this 15%, this probably this is also one more flexibility that you have. So, this is how the taxation kind of works.
Anything specific for senior citizens that one must be keeping in mind?
The key thing to remember is that your income will need to adjust. Most people come with the fact that 4-5% seems very conservative. Why don’t I go for 8%? But the problem is you also have to realize that this amount will have to consistently grow every year because there is at least a 5-6% inflation that you will have to account for. That means you will have to start with a slightly lower amount and your corpus will have to be at least 25 times to accommodate for this increasing monthly requirement that you will have.
So, the first thing is do not forget inflation when you are accounting for your monthly income solution. The second part is that volatility is almost a given. So, in that sense, a 10-20% fall happens in equity markets almost every year. When we looked at the last 43 years, there were only 3 years where the fall was less than 10%. Every other year had a fall of more than 10%. So, 10-20% is a given. And once every 7-10 years, there will also be a larger fall of say close to 30-40-50%.
Covid was a classic case. 2008 was a classic case. 2000 was a classic. But these are very rare. They are once in 7-10 years. But obviously, for a retirement tenure of 30-40 years, you will at least have 3 or 4 instances of a very large fall. So, you will have to be mentally okay that there will be one, two year temporary periods where your portfolio might seem to be reducing a lot. But again, for the alternative, you should avoid equity. But that is also not a great suggestion because otherwise, you will never be able to get the growth in your portfolio.
So, the equity component definitely has to be there. If you start reducing your equity component while the volatility reduces, you will also impact the third part, which is the growth in your portfolio. So, to balance it out, you need equity. You need to be okay with the volatility, which is why we built that 15% net so that every time there is a fall, you can shift your SWP into the safer debt funds. Then again, get back to this once the market recovers. Overall, putting it together, do not forget inflation. Make sure you have some equity portion. Also, depending on the equity portion, be prepared for temporary falls. You will have to ride them out.