My Journey with Mutual Funds and Passive Income Generation

During my academic years, money was a big concern for me. I was fully indulged in my academic routine & there was no active source of income for me. I am a big bibliophile and most of the books I read about finance had one topic in common, which is passive income sources. Most of the book emphasized on the importance of having a passive income source apart from an active income source. The sole reason behind the concept of passive income was that your active income source might get disrupted but your passive income source will always ensure your financial security. When I initially started my career as a research analyst and began working with mutual funds, I stumbled upon the concept Systematic Withdrawal Plan (SWP)—a strategy that revolutionized my outlook on income generation and capital preservation. SWP offers a continuous cash flow while simultaneously nurturing your investment's growth. It was the perfect solution to my recurring concerns about a passive income source.

Understanding the Systematic Withdrawal Plan (SWP) Strategy

SWP permits you to withdraw a fixed or adjustable amount of your mutual fund investment at designated intervals, such as monthly, quarterly or yearly. This method is devised to maintain a reliable income stream while ensuring that your invested capital continues to flourish.

The Essence of SWP: Balancing Earnings with Capital Preservation

The SWP strategy extends dual benefits:

1. Recurring Income: You receive dependable payouts, typically on a monthly, quarterly or yearly basis.

2. Capital Appreciation: Provided your withdrawal rate stays below the fund's return rate; your corpus remains on a growth trajectory.

Mechanism of SWP: How It Operates

When you select SWP option, the mutual fund company liquidates a portion of your units to fulfill your withdrawal request. Assume you have invested ₹60 lakh & the Net Asset Value (NAV) of your fund stands at ₹500, and your monthly withdrawal requirement is ₹25,000. In this scenario, the total number of units that you will receive on your ₹60 lakh capital at a NAV of ₹500 is 12000 units. Now assume your monthly withdrawal requirement of ₹25,000 starts after 1 month. The NAV at that time is ₹510. In this scenario, 49 units would be sold to meet your income needs, while the residual units stay invested, benefitting from market structure.

Fixed vs. Flexible SWP

• Fixed SWP: Withdraw a predetermined sum at regular intervals, offering predictability and security.

• Flexible SWP: Adjust withdrawal amounts according to market conditions and your evolving financial circumstances.

Simple Logic of SWP: Income Generation Without Capital Exhaustion

A withdrawal rate of 5% paired with an annual return of 9% enables the remaining 4% to contribute to the growth of your investment corpus. For example, with a ₹60 lakh corpus and monthly withdrawals of ₹25,000, you secure a steady income stream while the additional return continues to enhance your investment.

SWP Strategy in Different Market Conditions: Let’s do some number crunching:

Mrs. Sharma is retired and receives a fixed monthly pension from her last employer. She has two children. Her son works for an IT company in another city and has settled there. Her daughter has just completed her higher education and moved to the U.S. for a new job. Her husband passed away five years ago, and her children are now able to support themselves.

Mrs. Sharma needs an additional source of income to cover her monthly expenses and maintain her current lifestyle. Her pension alone is not enough to meet her needs.

Her financial advisor has suggested that she use a part of her retirement savings to start a Systematic Withdrawal Plan (SWP) with hybrid funds. This plan would provide her with a regular income while allowing her investment to grow over time. Mrs. Sharma is concerned about market fluctuations and the timing of withdrawals.

To help her understand, her financial advisor has explained her the process using the following table:

He did a case study with Mrs. Sharma to address her concerns. He took ₹60 lakh as the investment corpus & plotted the effects of SWP on the invested corpus in different market circumstances. The changes in market condition are prevalent from the fluctuating NAV values at different time frames. He added that SWP is dynamic in different market conditions. In a bull market, fewer units get sold to generate the same withdrawal, ensuring higher growth of your remaining corpus while in a bear market, more units get sold, as you can see in the table above. It is very important to note that the rate of return should be higher than your withdrawal rate. In this particular scenario the rate of withdrawal annually is set at 5% & expected rate of return is set at 9% annually. There is a 4% growth in the invested capital yearly which ensures the preservation of the invested capital as well as appreciation. As it is already evident from the above table that, when the NAV moves up, despite the regular payouts, the invested corpus stays at the same level or appreciates. It not only preserves the capital but also provide protection from the effects of inflation on the invested capital over the long-time horizon.

SWP vs. Conventional Income Channels:

Compared to fixed deposits and dividend-yielding stocks, SWP offers:

• Growth Potential: FDs generally yield lower returns (6-7%), whereas mutual funds can generate 9% or more over an extended period.

• Lower Volatility: Dividends from stock investments can fluctuates or face uncertainty but SWP ensures steady stream of income.

• Tax Efficiency: Only the capital gains portion of your SWP withdrawals is taxed, unlike the fully taxable interest on FDs as per your slab rate.

Important considerations before starting SWP:

• Your SWP strategy is aligned to your short-long term financial goals.

• Your investment is tailored to match your risk appetite.

• Your invested capital is enough to generate your desired periodic payout while ensuring capital preservation.

• Your withdrawal rate is lower than your rate of return on investment.

• Periodic review of your investment performance and risk alignment is important.

Conclusion:

Systematic Withdrawal Plan (SWP) offers a flexible and effective way of ensuring consistent income source while preserving your capital and potentially appreciating it. It has advantages like steady payouts, growth potential & tax efficiency. For getting the best outcome, align your SWP strategy with your financial goals. If you need more clarity or assistance, seek advice from a finance professional. Happy Investing!