Systematic Withdrawal Plans (SWP) are very popular ways to derive income flows from mutual funds. If you have a SWP currently running, you must take the time to re-evaluate the merits in this bear market.
How does a SWP work?
Some mutual fund companies like Templeton and Trimark were leaders in promoting the SWP plan. Let's go through an example: if you invest $100,000 the first step is to determine the appropriate level of income. Let's assume we decided that we wanted a 10% income on the $100,000. This would mean that we would get paid $10,000 per year or $833.33 per month. You have the flexibility of setting any income target you want at any frequency (monthly, quarterly, semi-annual, and annual).
If the mutual fund earns 10% then theoretically your $100,000 capital should stay intact. If you earn 12% then your portfolio will grow and if you earn less than 10% your capital will drop.
Historically, the Templeton Growth Fund has a 20-year return of 13.17% compounded and the Trimark Fund has the best 20-year return of any global equity fund with a 16.36% compounded return. Given these returns over the long term, despite the re-occurrence of bear markets, your capital would have grown dramatically at a 10% income level.
Reverse dollar cost averaging
When you create a ‘fixed dollar' income, the income plan is mathematically inefficient, particularly in bear markets. Let's say the mutual fund is priced at $10 per share. If we want $833.33 of income, you will need to sell 83.3 units to create that income.
|Unit Value||Income||# of units sold|
|$ 10.00||$ 833.33||83.333|
|$ 10.50||$ 833.33||79.365|
|$ 11.00||$ 833.33||75.757|
|$ 9.00||$ 833.33||92.592|
|$ 8.00||$ 833.33||104.166|
|$ 7.00||$ 833.33||119.047|
If a bear market hits, and you see a 30% drop in the fund you will need to sell 119 units to keep the same $833.33 of income. A 30% drop means you have to sell over 42% more units to keep the same income.
Anyone with SWPs today will feel the pain as markets go through one of the worst bear markets in post war history.
My two cents
If you have a ‘fixed dollar' income plan where you are investing in equity based mutual funds, you should sit down and evaluate the risks of such a plan in today's markets. This may apply to non-registered SWPs as well as mutual fund RRIF plans. If you have a financial advisor, now is the time to take a look at how SWPs are affecting your wealth. Here are some of my thoughts on the topic:
- Keep cool and stick with it. Both the Templeton Growth Fund and the Trimark Fund have illustrations that show how SWPs work in the long run despite bear markets. As painful as it can be right now, the future will get brighter.
- Consider a lower income for a temporary period of time. If you have the financial ability to do so, consider lowering or stopping the income for a period of time so you are not selling more units at firesale prices.
- Take a look at some income funds as an alternative. Let the manager of these funds manage the income levels. They in turn anticipate income distributions frequently and will manage your funds with more liquidity in mind. Reverse dollar cost averaging may not be as big an issue with income funds. With the markets where they are, some of these income funds are providing very attractive incomes.
- Take a bigger picture view of your portfolio. You might be better off stopping any SWPs from equity based funds and start them on other funds like money markets or bond funds for a temporary period of time.
- Watch the tax implications of making changes. If you have a non-registered SWP, and you plan to make a change, remember that any change can trigger tax.
- Switch from monthly income to annual income. Try to give the markets some time to rebound before withdrawing any income. Deferring the income may work against you if markets keep going down. Keep in mind that market timing is near impossible.
It's a tough time for any equity investor but when you are selling into a bear market I think you need to be even more aware of the potential implications.