Why debt funds score over equity, hybrid schemes for systematic withdrawals

A SWP facilitates automatic withdrawal of a fixed amount of money from your lump-sum investment and is credited to your bank account - monthly, weekly, as per the frequency decided by you.

A systematic withdrawal plan (SWP) enables you to withdraw a fixed amount from a mutual fund at regular intervals. It is the opposite of a systematic investment plan (SIP), where you invest in a fund at fixed intervals.

SWPs are convenient for anyone who needs a regular income. It is more relevant for retirees, but its utility need not be confined to retirement goals alone. It could be used by a startup entrepreneur to fund his living expenses in the initial years.

SWPs are also tax efficient as the withdrawals are spread over a longer period of time, which defer taxation and let the rest of the principal amount compound.

How SWPs work

An SWP facilitates automatic withdrawal of a fixed amount from your lump sum investment on a monthly or weekly basis.

For example, suppose you have invested Rs 10 lakh in a mutual fund and require Rs 20,000, say, on the third of every month. You can set up a SWP and the fund will redeem units equivalent to Rs 20,000 on the third of every month at the prevailing net asset value (NAV).

During the withdrawal period, if the scheme's NAV has been appreciating, your final investment value may still be higher than what you started with. You will be left with fewer units though. But two things are likely to deplete your fund easily:

1.       If your withdrawal is at a rate higher than that at which the NAV has been rising, and / or

2.       A consistently depreciating NAV.

Also read | SIPs work in debt mutual funds too. Here’s why this is the right time to invest

How to invest for steady withdrawals

The broad objective of SWPs is to provide regular cash flow. Hence, it is imperative that the capital investment is protected from volatility. Therefore, debt mutual funds are most suitable for this.

These are extremely low in volatility as the returns are earned through interest accruals. Of the various debt fund categories, liquid funds are the best option for safe and steady returns. Ultra-short term and low-duration funds can also be considered for SWPs, although it is suggested that an investor invests in such funds for at least six months to a year, and then starts withdrawing. Additionally, you can ensure that the fund selected has invested in AAA-rated papers and does not carry credit risk.

Other categories like short term, medium term, and dynamic bond and gilt funds can be avoided for SWPs, as they hold long-term securities and are volatile with greater exposure to interest rate risk.

Also read | 7 Midcap stocks that the government run pension schemes love to hold

Are equity funds suitable for SWPs?

Volatility in returns would imply that your investment will not grow steadily enough to comfortably withdraw from. Just as fewer units need to be redeemed for SWPs when equity markets are on the rise, likewise, more units need to be redeemed to fund the SWP in a falling market. So, volatile options like pure equity funds are out of question for withdrawals.

Hybrid options like balanced advantage funds or conservative hybrid debt funds can be considered for SWPs. It is, however, suggested that withdrawals from these funds are planned carefully. Some interesting market data from the downfall during Covid would support this view.

Source: Morningstar

Disclaimer: The funds mentioned are only for illustration purposes and not proposed as any recommendation from the advisor.

The chart above shows the monthly rolling returns of the top balanced advantage funds (by AUM) starting from April 2019. The rolling returns are calculated thus — e.g., 1/1/20-1/2/20, 2/1/20-2/2/20, and so on. You will observe that the month-on-month returns started falling from February and the fall accentuated towards the end of March because of the lockdown, where returns were negative 25-30 percent compared to the previous month.

Conservative hybrid funds have also shown a similar trend although they have fallen lesser, in the range of 5-15 percent per month during the same rolling period. Covid was a black swan event, but markets usually undergo intermittent declines every year.

It is thus prudent to let your lump  sum investment grow and compound for at least three years before you start withdrawing from a hybrid fund.

Another alternative, especially if you are a retiree, is that you park monies equivalent to three years' expenses in a debt fund, and invest the rest in a hybrid fund. Once your debt bucket is nearing depletion, you can replenish from the equity bucket for another three-year requirement.

A reasonable withdrawal rate and a long-term investment horizon of 10-15 years would help your corpus grow and last long enough.

Hybrid funds are suitable for SWPs only if you can stomach the periodic volatility in the markets. Else, a debt mutual fund would be the best option to withdraw from for peace of mind.