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Crafting A Withdrawal Policy Statement For Retirement Income Distributions

Posted by Michael Kitces on Wednesday, February 26th, 7:01 am, 2014 in Retirement Planning

Helping clients stay the course in the midst of market volatility is a challenge for any advisor, and one that is only exacerbated when those clients are taking retirement cash flow distributions. As the retirement research has shown, when market volatility occurs in the midst of ongoing withdrawals, there is a "sequence risk" that too many bad returns in a row can deplete the portfolio before the good returns finally show up.

While planners do their best to help clients stay invested, retirement researcher and financial planning practitioner Jon Guyton suggests that the best approach may be to craft a "Withdrawal Policy Statement" (WPS) for clients. Similar to an Investment Policy Statement (IPS), the goal is to articulate a series of parameters and guidelines about how retirement withdrawals will be funded from the portfolio, to clarify how to respond when a market calamity strikes and determine, in advance, what steps will be taken to keep the plan on track.

Of course, the reality is that any such changes that are planned in advance could simply be decided in the moment as well. Yet given how emotional a scary market environment can be, Guyton makes a compelling case that having a WPS in place may help to ensure that clients don't do anything rash. After all, we might all say we have a plan to deal with a market decline, but is it really a plan if the guidance about how to fund withdrawals in the midst of market volatility hasn't been written out in advance?


What Is A Withdrawal Policy Statement?

The idea of a withdrawal policy statement was first published several years ago in the Journal of Financial Planning by financial planner Jon Guyton. The basic concept is that, just as we establish an Investment Policy Statement (IPS) that sets forth the parameters about how investments will be managed on an ongoing basis, the Withdrawal Policy Statement (WPS) establishes similar parameters but in the context of how portfolio withdrawals will be implemented to generate retirement cash flows.

Just as with the IPS, and purpose of the WPS is not to articulate goals themselves, but to be descriptive about how the withdrawals (or investments) will be managed in a manner that aligns with the long-term goals. As Guyton explains, the purpose of the WPS is to be broad enough to handle unexpected situations, but specific enough that there is little doubt about what to do when those situations arise.

Of course, it's always possible to just manage these situations as they arise. But the purpose of the WPS is to set clear expectations about how unexpected situations will be handled in advance, and the tools and tactics available to address situations, to reduce the uncertainty and make it easier to stick to the plan.

By analogy, think of rebalancing in a portfolio; while clients could simply choose to buy more equities when the market is down, that can be a very difficult tactic to implement in practice in the heat of the moment. When there is a policy that already stipulates periodic rebalancing under certain conditions, the uncertainty of what to do is removed (even though we won't necessarily know exactly what the market conditions/events will be that give rise to a rebalancing trade), the default strategy is set, and it's much easier for clients to follow through accordingly.

Key Provisions Of A Withdrawal Policy Statement (WPS)

So what exactly would a Withdrawal Policy Statement contain? Guyton suggests that a WPS cover 5 key areas:

(1) the client income goals to be met via withdrawals;

(2) the client assets to which the WPS applies that will fund those income goals;

(3) the initial withdrawal rate;

(4) the method for determining the source of each year's withdrawal income from the portfolio; and,

(5) the method for determining the withdrawal amount in subsequent years, including both the trigger points for adjustments other than an inflation-based increase and the magnitude of the adjustment itself.

Of course, the first two items would normally be articulated in a financial plan already, and the 3rd item - the initial withdrawal rate that will be used to set the client's target spending floor - is relatively straightforward to set without a policy statement. The real keys are the 4th and 5th items, which truly establish a "plan" for how the retirement cash flows will be funded and implemented... and adjusted as circumstances unfold.

For instance, the 4th item might stipulate withdrawals primarily from cash and fixed income assets, but not equities unless they were up in the prior year (or there are no other cash/fixed funds remaining), and that interest and dividends will be held in cash (and not reinvested) to further supplement the cash pool to facilitate withdrawals.

Similarly, the 5th item might specify something like the rules Guyton actually used in his own prior research on decision-rules-based withdrawal rates, where spending is increased each year by inflation (but only if prior-year returns were positive), and the current withdrawal rate will be continuously monitored where spending is cut if the current withdrawal rate rises more than 20% from where it started (e.g., rising above 6% if it started at 5% initially), and spending can be boosted if the current withdrawal rate falls by more than 20% from its origin (e.g., falling before 4% after starting at 5%).

Practical Implications When Planning For Retirees

As noted earlier, the reality is that any of these strategies could simply be implemented with a live decision-making process in the moment, rather than being articulated up front in the form of a Withdrawal Policy Statement. There's nothing necessarily different about what is going to be done, simply because it's articulated in a WPS ahead of time.

However, reacting in the moment to whatever is going on is, almost by definition, not actually a plan. And unfortunately, given the reality that the time for negative adjustments is going to be when markets may be most volatile or outright in frightening decline, trying to react objectively in the moment may not be likely; instead, if the situation demands action and there is no plan up front, the next step is likely to be an emotional one, that risks derailing the long-term goals even further (e.g., selling out of markets entirely in the midst of a decline).

Accordingly, the real point of having a WPS is that it is a true articulation of an actual plan about how to deal with a market decline, as it specifies exactly how cash flows will be generated, where withdrawals will be taken, and - when paired with an Investment Policy Statement as well - what investment changes may or may not be implemented in response. In other words, just planning to make adjusts if/when/as the markets do whatever they're do is not actually a plan... but having a WPS to follow actually is a real, actionable, implementable plan.

And the ultimate goal of having such a plan? Making it easier for a client to actually follow the plan in the heat of the moment. In other words, at the end of the day having a WPS is about managing behavior, and from that perspective appears to be a very effective potential strategy, because it appropriately sets expectations and makes it clear how to act in the face of uncertainty. In fact, it can potentially help to alleviate stress in the face of market volatility simply by making it clear when it is time to worry and act, versus not.

Example. A client's $1,050,000 portfolio plummets sharply to $930,000, that may be terrifying in the absence of any other guidance, but if the client was spending $55,000 then the reality is the withdrawal rate just went from 5.2% to 5.9%... yet the WPS has already stipulated that no action needs be taken until the withdrawal rate is over 6%, so the client doesn't need to worry until the portfolio falls below $916,000. And of course, even at that point, there's no real worry, because the action plan has already been set: spending will be cut by 10% if the current withdrawal rate rises above 6%.

Compared to what otherwise is the terrifying uncertainty of "Have I lost too much money? What about now? What about now? When am I down too much to recover? How do I know when to act?" the WPS approach has set forth clear targets about what is nothing to worry about, what is a decline that's far enough to be actionable, and what is the appropriate action to take to get back on track (also making it clear that other, more drastic actions like bailing out, are unnecessary).

In other words, at the end of the day having a WPS turns the scary uncertainty of market volatility into a series of clear thresholds and specific action steps to take in response, which helps to manage expectations and takes much of the actual uncertainty out of the process, converting it instead to a simple monitoring of risk - if (A) happens, we have a plan to do (B) in response to stay on track. While that doesn't guarantee to take away all client emotions, it provides a clear default of what should be done, which at least has a better chance of being actually implemented in the midst of an emotionally scary time. And of course, the WPS isn't just about disasters; it also specifies the conditions under which spending can rise as well, giving clients something to shoot for on the upside as well.

If you're curious to try implementing a Withdrawal Policy Statement yourself, Guyton has been kind enough to share this Withdrawal Policy Statement (WPS) sample version you can use as a template.

So what do you think? Have you ever used anything like a Withdrawal Policy Statement in the past? Do you see it as something that could complement an IPS as well? Do you believe this could help clients to better navigate the next inevitable bear market when it arrives?


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