The systematic withdrawal plan (SWP) is one of the most commonly used and misunderstood methods of structuring a retirement income plan. Deceptive in its simplicity, the potential benefits are often overemphasized and the relevant risks understated.

As with all retirement income plans, an SWP must be thoroughly considered before deciding if it's the right choice for you.

Key Takeaways

  • Setting up a systematic withdrawal plan to manage retirement income is not as simple as it may seem.
  • It’s crucial to understand how rate of return works and the impact of a bear market on the amount of withdrawals needed to maintain your lifestyle.
  • A systematic withdrawal plan can be set up using individual securities, mutual funds, or annuities, but a combination of the three may be a good idea.
  • After implementing a plan, don’t neglect your portfolio because projected retirement income could come up short.

The Basics of SWPs

The basic idea of an SWP is that you invest across a broad spectrum of asset classes and withdraw a proportionate amount each month to supplement your 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 a hedge against inflation, during retirement.

Understanding How Rate of Return Works

Setting up a scheduled investment withdrawal plan during retirement may sound simpler than it actually is. The complexity, and potential problem, is the average rate of return assumption.

Most investors look at a portfolio's average rate of return to determine whether or not they have enough money to retire. But a retiree usually isn't interested in the average but rather the annual rate of return. It doesn't matter much that the portfolio averaged 8% when, in the first year of retirement, it loses 20%. In this case, you've dug yourself a big hole, and it may require a long time to get out.

Another issue, which is not dissimilar to an interest-only strategy (in which you buy fixed-income investments and live off the interest), is liquidity. In an SWP the investments are generally quite liquid, meaning they can be sold if the principal sum is needed for an emergency or a large expense. The problem is that if you've made your income assumption based upon your total sum of assets, then withdrawing a large amount changes the future rate of return you'll need.

Let's say, for example, that you retire with $1 million and need a 7% rate of return. You have an unexpected need for capital and withdraw $50,000. Your necessary rate of return increases from 7% to 7.37% ($70,000/$950,000). Even that slight change can have a big impact long term. This implies that the investments have to be performing at a higher level than initially expected.

As with interest-only securities, SWPs work best for investors with excess investable dollars. That way, if a withdrawal is necessary, or if your rate of return assumption didn't quite work out, you might still be able to maintain your standard of living.

How to Construct an SWP

SWPs can be constructed using individual securities, mutual funds, and annuities, or a combination of the three.

The basic fundamentals of an SWP suggest that the rate of investment growth has to exceed the money paid out.

Individual Securities

Buying individual securities is a more complicated way to build a plan, but many investors prefer ownership of individual stocks and bonds to mutual funds. An issue with this approach is that most brokerage firms don't provide an SWP program for individual securities. Depending on your brokerage firm's commission schedule, using provided products can help you, as a retiree, diversify holdings and lower transactions costs.

Mutual Funds

A more common way to construct an SWP is with mutual funds. Mutual funds can often be sold without large transaction fees (depending on the fund you own and the class shares), and most brokerage firms provide an automatic SWP program. With an automatic SWP program, all you need to do is fill out a form and tell your brokerage firm how much you want to receive each month and where to take it from, and the sales will occur automatically. This is a convenient feature that gives investors the feeling of receiving a pension or annuity check.

The problem is that once on auto-pilot, the accounts are sometimes not analyzed properly by the investor to determine if the portfolio is earning a high enough rate of return to maintain the withdrawal rate. It is often only when it becomes obvious that the portfolio is being drawn down more quickly than anticipated that the investor seeks professional help. As with the individual security portfolio, a surplus of cash can help offset the risk.

Annuities

Another option is to use an annuity to protect against running out of money. There are many different kinds of annuities and not all are appropriate to build an SWP.

The type of annuity that may help in an SWP is one that provides a guaranteed minimum withdrawal benefit (GMWB). With this kind of annuity, the insurance company guarantees a cash flow amount based upon your original investment. If you invested $1 million in an annuity with a GMWB, you would receive payments over the rest of your life at a predetermined rate, usually between 5% and 7%.

If the portfolio didn't provide enough return to sustain the cash flow rate and the value of your investments declined in a bear market, the GMWB would provide regular payments to recoup the initial value of the portfolio. Naturally, you wouldn't put all of your money into this type of annuity—or any investment, for that matter—but this may be a useful tool for investors who are on the cusp and concerned about depleting their assets.

Pitfalls to Avoid

A blended approach to SWPs is likely the best approach. Any of the above-mentioned options may be utilized effectively, but the proof is in the pudding. Make sure to avoid the following pitfalls.

Erroneous assumptions regarding rates of return or inflation can be hazardous to any portfolio. Also, mismanagement or neglect alone can ruin the best laid plan. The prospects of eroding your portfolio are high. Paying close attention to what's happening in your portfolio is the only way to prevent a catastrophe.

As mentioned earlier, it is the annual or current rate of return that matters, not the average. Imagine investing that $1 million and needing 7% cash flow when the market fell by 40% due to a recession. Even if your portfolio is 50% stocks and 50% bonds, you can assume it would be down approximately 20%.

So let's say that, in year one, you withdraw $70,000 and the portfolio falls by 20%. Your portfolio value would then be reduced to $730,000. If in year two, you withdraw $70,000 from $730,000, you are withdrawing 9.6% of the portfolio, assuming steady equity and bond prices.

This example is based on a once-a-year withdrawal, but most people withdraw monthly, so you get the picture. The recommended percentage assumption for a sustainable withdrawal rate is approximately 4%, leaving room for inflation. And even at 4%, you could still end up depleting your portfolio to some degree after a large decline in the stock markets.

The Bottom Line

SWPs are useful and effective when handled properly and can be disastrous when handled improperly. It's best to consider all types of retirement income plans and seek the guidance of a professional in order to truly be confident in your ability to maintain your standard of living and/or leave a financial legacy to your heirs.