Cognitively Yours 1.13

 

Raja R, Author

"Planning “to the retirement” is important but equally important is planning “through the retirement”. Systematic Withdrawal Plan (SWP) help you to achieve the objective of regular cash-flows post retirement"

In the previous blogs, we discussed how mental shortcuts though needed to take quick decisions do induce us to make errors in investing. We also saw how diversification helps us reduce risk and how it is almost a free lunch in minimising risk without reducing the returns. In the last post, we saw the benefits of a Periodic Investment Plan or Systematic Investment Plan (SIP).

Periodic Investment Plans are loosely called as Systematic Investment Plans. Investing regularly to create a nest egg is an important leg of financial planning and is a necessary requisite for a successful wealth creation. But, it is not sufficient. To make the Periodic Investment Plan systematic, one has to have a proper asset allocation to achieve the goals, evaluate at regular intervals whether the plan is on the right track to achieve the goals and do the rebalancing to ensure that the plan is on the right track.

In Hindu philosophy, in "Narasimhavatar" after seeing lion head and human body combined like people hate to see any other form individually. This analogy of matching unmatched ones can be extended to “Portfolio Construction” where we combine different asset classes with varying traits to perfect unison. Equity has traits of lion-volatile, unpredictable in behaviour, may cause harm to one if not handled properly, powerful and effective if put to use efficiently while debt has the traits of human-predictable, calm, safe and not much gap between expectation and reality. The combination of equity and high quality debt in one’s portfolio moderates the ferociousness and unpredictability of equity with the docile and predictable nature of debt.

When we speak of Systematic Investment Plans, we stop up-to creation of corpus say for retirement. We do lose sight of how the corpus is utilised to satisfy our needs. Planning “to the retirement” is important but equally important is planning “through the retirement”. How cash flows are generated post retirement from the nest egg also forms part of financial planning. Systematic Withdrawal Plan (SWP) help you to achieve the objective of regular cash-flows post retirement.

SWP is one of the most commonly used methods of structuring retirement income plan. The basic tenet of an SWP is that one invests across a broad spectrum of asset classes and withdraw a proportionate amount each month to supplement one’s income. The assumption is that, over time, the SWP will produce an average rate of return sufficient to supply the needed income as well as inflation hedge, in a tax efficient manner.

SWPs can be constructed a number of ways, and these are not mutually exclusive. One way is through buying individual securities. A more common way to construct an SWP is with mutual funds. With an automatic SWP program, all one needs to mention it at the time of purchase of units, or subsequently through a separate application form and the investor will receive it at periodic intervals viz. monthly, quarterly or at specified intervals required by the investor. An SWP is an income planning strategy that is simple.

1. SWPs are habitual, conventional and in-line with the needs of investor

An investor who plans for retirement, builds a nest egg or corpus on retirement. However, the needs for an investor is a portfolio that gives him periodic cash flows through the target retirement date, with a focus on income beyond the retirement date. SWP mimics annuities of a defined contribution plan and provides cash flows beyond the retirement date.

2. SWPs inculcate a disciplined approach on achieving a financial goal like retirement, child’s career  etc.

SWP’s disciplined approach help investors to overcome behavioral biases. SIPs may ensure creating a nest-egg for retirement. But, post retirement, one needs periodic cash flow to take care of one’s needs.  SWPs takes you through retirement. Similarly, for other goals too, there would be necessity for periodic cash flows which can be met through SWPs.

3. SWPs provide multiple bets for exit

Systematic withdrawal helps people to frame the investments as multi-round opportunities rather than each investment as an one-shot opportunity.

People evaluate one-shot gamble in isolation from other decision problems and record the possible outcomes for each of these gambles in separate mental accounts. Systematic withdrawal provide multiple points of exit. Some of the exits may not be at opportune times known in hindsight and some of the exits would be at opportune times again known in hindsight. SWPs ensure that one gets an average of the redemption prices - reverse of SIPs’ benefit of rupee cost averaging.

Redeeming smaller amounts in the form of multiple bets offer time diversification, where the people may feel that they have law of averages by their side.

4. SWPs are tax efficient

Dividends are considered as income and taxed based on one’s marginal rate of taxation. Cash flows from SWPs consist of capital gains as well as principal amount redeemed.  Tax will be on capital gains, if any and not on the principal which forms part of redemption amount. Hence, tax as a percentage of cash flows will be minimal. Moreover, when your investment is not doing well, there may not be capital gain and the cash flows will not be taxed. On the other hand, in case of dividend, even if your investment has depreciated, dividends will be still subject to taxes.

SIPs are like entering the “Padma Vyuha”. It helps toward formation but at the same time one should have a strategy to exit the formation after realising your goals. SWPs help you exit the formation and help you to achieve your goals. Without a proper exit strategy, one will be caught unaware like Abhimanyu and meet a similar fate like him. SIPs combined with SWPs and a proper asset allocation strategy will help you achieve your financial goals.

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