You should choose a systematic withdrawal plan carefully so your money doesn’t run out before you do. A 1997 book, Die Broke, advocated planning your finances so that “The last check you write should be to the undertaker–and it should bounce!” A cheeky suggestion, of course, but there are better ways to plan living off your investments.
Living off your investment portfolio may be the most difficult part of the whole life investment cycle. Unless you want nothing more than interest from a portfolio of conservative fixed-income investments, dealing with the unknowns of the future should make you err on the side of conservatism.
Systematic withdrawal programs for income make intuitive sense. You create income by redeeming annual amounts from your fund about equal to its long-term growth rate.
But when you look a little more closely, some of the appeal fades. If you go at it carelessly, you can permanently impair your portfolio.
Suppose you hold $100,000 in a conservative, core fund — Canadian or global. And suppose that fund boasts a 10-year record of 10 per cent a year. A systematic withdrawal plan might suggest you redeem $10,000 worth of the fund each year in the hope of replacing it through investment gains. Most funds, in fact, will let you take 10 per cent without triggering a deferred sales load.
But even in the most conservative stock funds, we suggest that’s taking too much risk.
Let’s suppose you invested in a solid, well-managed, core fund such as ABC Fictional Fund a year ago and set up a plan such as the above.
Let’s also suppose that at the end of the first year, when you take $10,000, your fund lost 20 per cent over the year. (Keep in mind that the average Canadian equity fund lost 34.2 per cent of its value in 2008.)
So after your withdrawal, your investment would be worth just $70,000. Now, to cover a further $10,000 next year, the fund would need to gain 14.3 per cent in the next 12 months.
In fact, if the fund gained 10 per cent every year thereafter, you would run out of money in about 14 years.
That’s the result of one bad year at the start of your program. If the fund should come up short of the 10 per cent in the second year, things would deteriorate even more quickly.
Systematic withdrawal of a fixed-dollar amount on a regular basis creates the opposite effect of investing by dollar-cost averaging.
You sell more units of your fund the lower the price, exactly the opposite of what you want. In a program of investing by dollar-cost averaging, you buy more units when prices are low — the ideal investment program.
To systematically draw an income from your investments, we suggest taking a fixed percentage of its value at the time of redemption.
This strategy will result in a variable income. In the above example, if you took 10 per cent of the ever-changing value, you’d get just $8,000 at the end of the first year. But a gain of 10 per cent in the following year would bring your holding to $79,200 at the end of the period, when you would take $7,920.
The MoneyLetter, MPL Communications Inc. 133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846