Retirement income: Systematic withdrawals now win over dividends

An investor's instinct to live off 'income' and not 'touch capital' is a common bias. Understanding it can lead to better, more tax-efficient withdrawal strategies

I was talking to our client Austin about deploying his retirement corpus. One of our key recommendations was to invest ₹5 crore in the growth option of a balanced fund and systematically withdraw an inflation-adjusted ₹2.5 lakh a month (₹30 lakh in the first year) over the next three decades. Austin understood the risks of using an equity-oriented balanced fund and was comfortable with the withdrawal plan. But he was clear that he preferred the dividend option. His worry was that withdrawing through a systematic withdrawal plan (SWP) in the growth option might, during weaker market phases, eat into capital. “It’s always better to live off income than touch capital,” he said.

 

In his preference for the dividend option, Austin was expressing an old investor instinct. Behavioural economists Hersh Shefrin and Meir Statman described this in their classic 1984 paper on why investors prefer cash dividends. Consider an illustration: You buy a stock for ₹100 and its value rises to ₹102. If the company declares a ₹2 dividend, you receive ₹2 in cash and your share value falls from ₹102 to ₹100; your total wealth is ₹102. If instead there is no dividend and you sell ₹2 worth, you again end up with ₹100 of stock and ₹2 in cash — the same ₹102. Selling a small portion is often more efficient because capital gains tax is usually lower than dividend tax. Yet investors overwhelmingly prefer the dividend because it arrives automatically and feels like “approved” income, while selling shares requires an active decision and feels like violating a self-control rule meant to protect principal. Austin was acting out this mental accounting pattern of separating income and capital.

 

Professor Statman illustrates how deeply the need to “spend only from income” can shape behaviour. He recounts the case of a wealthy retired executive who accepted a couple of board directorships solely so that the fees could justify spending he considered extravagant. Drawing from his accumulated wealth felt uncomfortable; spending from a fresh flow of income felt acceptable.

 

Social media caters to the same instinct. It is full of videos urging people to “build a second income”, with monthly rent, dividends or interest cheques taking centre stage. The emphasis is almost always on generating an income stream and rarely on building the corpus from which that income must flow. Yet a second income alone is rarely enough. Rental, interest or dividend income can be useful parts of a retirement plan, but they cannot by themselves form a reliable lifetime withdrawal strategy. In Austin’s case, preserving his principal of ₹5 crore indefinitely while withdrawing the amounts he wanted would have required a much larger corpus. Withdrawing only from income, rather than withdrawing in a disciplined manner, demands far more capital than most people imagine.

 

Once Austin became aware of the bias and saw the significant tax advantages of harvesting gains rather than relying on dividends, he was more open to an SWP from the growth option. However, as financial planners know, these conversations are difficult. The income-versus-capital divide is deeply ingrained, and planners often find themselves responding to a behavioural instinct rather than a financial argument.

 

This is where the mutual fund industry can play an important role. It is possible to design an SWP variant that allows withdrawals only from gains, with a client-specified maximum limit. Such a structure would satisfy the mental-accounting need to keep capital untouched, meet the self-control need to operate within a clear rule (“withdraw only if there are gains”), and still automate the process so the investor need not take any emotionally fraught action. A tagline like “Be disciplined — withdraw only from gains” could make such a product intuitive and acceptable to a large class of investors.

 

Truth be told, investors’ behavioural needs matter, and product design that acknowledges these needs can significantly improve investor outcomes. Until such behaviour-aware products become more common, investors will need to listen to their financial planners, recognise their own mental biases, and avoid decisions that may undermine their financial well-being.

 

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; 

X : @harshroongta