Systematic Withdrawal Plan

Perpetua Halloway, 68, has $420,000 in a balanced mutual fund and asks her agent to set up a SYSTEMATIC WITHDRAWAL PLAN paying her $2,800 a month. The agent tells her the plan will "guarantee her that income for life" and that "the fund's returns will cover the withdrawals, so the principal stays intact." What is wrong with the agent's description?

1. A.Nothing, provided the fund's historical average return has exceeded the withdrawal rate.Past averages do not guarantee future payments. The representation of a lifetime guarantee remains false.
2. B.The plan guarantees nothing; withdrawals exceeding returns are met by redeeming shares, which permanently reduces principal.Correct. A systematic withdrawal plan governs mechanics only, and shortfalls are funded by selling shares.
3. C.The error is only that he failed to disclose the sales charge applicable to each periodic withdrawal.The central defect is the false guarantee of lifetime income and intact principal, not an undisclosed charge.
4. D.Systematic withdrawal plans may not be offered to investors over 65, so the plan cannot be established at all.There is no age prohibition. Such plans are commonly used in retirement; the problem is how this one was described.

Why: A systematic withdrawal plan is a mechanism, not a guarantee. It instructs the fund to redeem enough shares each period to pay a fixed dollar amount, and nothing about it assures that the amount can be paid indefinitely or that the principal will survive. Whether the account lasts depends entirely on the relationship between the withdrawal rate and the fund's actual returns. If returns fall short of $2,800 a month, the shortfall is met by redeeming shares, which permanently reduces the number of shares owned and therefore the capital available to generate future returns. In a falling market this effect accelerates, because more shares must be sold at lower prices to produce the same dollar payment. Describing the arrangement as guaranteeing income for life and preserving principal is simply false.

The primary risk of a systematic withdrawal plan is:

1. A.Depleting principal if withdrawals outpace growthCorrect - overdrawing erodes principal.
2. B.Income is guaranteed for lifeA lifetime guarantee is what annuitization provides, and it is exactly what a systematic withdrawal plan lacks. The plan pays out of a pool of fund shares that can run dry; the insurer's promise to keep paying no matter how long the client lives is the feature being given up in exchange for retaining control of the assets.
3. C.Withdrawals are always tax-freeEach withdrawal is a redemption of shares, so any gain over basis is taxable, and the fund's own dividend and capital gain distributions are taxable along the way. Beyond that, a favorable tax result is not a risk at all, so the answer does not respond to what the stem asks.
4. D.There is no riskThe steady arrival of a fixed check makes the arrangement feel safe, which is the illusion the question is testing. The underlying shares still fluctuate, and taking money out during a decline forces the sale of more shares at lower prices, accelerating the drawdown.

Why: If withdrawals exceed the account's growth, the investor can deplete principal.

Cordelia Fanshawe establishes a systematic withdrawal plan on her mutual fund account and elects a FIXED-DOLLAR withdrawal of 2,000 dollars per month. Her representative walks her through how the plan will behave over time. Which statement is correct?

1. A.The plan guarantees her 2,000 dollars per month for as long as she lives.Wrong. A withdrawal plan carries no guarantee; only an annuitized insurance contract can promise lifetime income.
2. B.A fixed-dollar plan liquidates the same number of shares each month regardless of share price.Wrong. That describes a fixed-share plan. A fixed-dollar plan varies the shares to hold the dollars constant.
3. C.The fund redeems whatever number of shares is needed to produce 2,000 dollars, so falling share prices force larger redemptions and can exhaust the account; the plan is not guaranteed and she may stop it at any time.Correct. Fixed dollars means variable shares, with faster depletion in down markets and no guarantee of any kind.
4. D.Because it is a fixed-dollar plan, each withdrawal is treated as a nontaxable return of capital.Wrong. Each withdrawal is a redemption of shares and produces a capital gain or loss measured against basis.

Why: Under a fixed-dollar systematic withdrawal plan the fund redeems whatever number of shares is required to produce the stated dollar amount each period. When the net asset value falls, more shares must be liquidated to raise the same 2,000 dollars, which accelerates the depletion of the account precisely when values are depressed. Nothing about the plan is guaranteed: it is an administrative service, not an annuity, and the shareholder may change or terminate it at any time. Each redemption is a sale that can generate a taxable gain or loss.

Marisol asks Denbigh Securities to set up a withdrawal plan paying her 5% of her Denbigh Balanced Fund account value each quarter, rather than a set number of dollars. Compared with a fixed-dollar plan, what should her representative tell her to expect?

1. A.Her payment will vary with the account value and the account will run out faster than under a fixed-dollar plan.The first half is right, the second is backwards. Depletion risk belongs to the fixed-dollar plan.
2. B.Her payment will rise and fall with the account value, but the plan cannot by itself exhaust the account the way a fixed-dollar plan can.Correct. Taking a percentage of the remaining balance leaves a balance every time.
3. C.The fund must guarantee the 5% payout rate for the life of the plan once it accepts her instruction.No withdrawal plan may be guaranteed, and representatives may not describe one as assured income.
4. D.Her payment will be the same every quarter because the withdrawal percentage is fixed.A fixed percentage of a changing balance produces a changing dollar payment.

Why: A fixed-percentage plan liquidates a share of whatever remains, so the check varies directly with the account value: larger after a good quarter, smaller after a bad one. Because each payment is only a fraction of the balance, the plan cannot mathematically drain the account on its own. A fixed-dollar plan does the opposite, holding the check steady while liquidating more and more shares in a falling market, which can exhaust the account.