Executive Summary
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. Or alternatively, you can use a software solution like Timeline to help illustrate the consequences of various retirement spending trade-offs, and then output the results to their Withdrawal Policy Statement 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?
I’ve used something along these line for several years. I give my clients a written set of instructions showing how the calculation is to be done each year. Then I train them in all the reasons why this is important. I have found its primary value has been to help clients stay calm during the ups and downs of markets while they are taking income from their portfolio.
I have been using something similar with my retired clients for the last year or so, but this is a bit more codified and I like it. I’d like to see more discussion of how best to develop the parameters – the starting withdrawal rate, the triggers (the example uses a WD Rate of 6.5% as the trigger to reduce distributions, etc.).
What I’ve been using is a spreadsheet that starts with their current asset balance, current withdrawal, and calculates the withdrawal rate. Then we adjust the withdrawal every year for inflation out to the “end of their plan,” say age 95, and calculate what the rate of return would need to be to have either a $0 balance (or a particular “legacy” balance at that point), and the required rate of return to get there. The first thing this does is gives us a talking point about what the required return would be – is it realistic given their risk tolerance? Second, we then figure out what the annual WD rate should be every year. As the WD Rate in this method typically rises every year, I’ve been using a variance, +/- 10% of the target WD Rate, as the trigger. Then, during one of our quarterly reviews every year, we can plug in the ACTUAL numbers (portfolio balance and current withdrawals) to see if we’re on track. This also guards against the CLIENT deviating from the plan by wanting to take more than we had discussed. Not as complicated as it sounds as I write it, but I haven’t been doing it long enough to really test the effectiveness.
David, how do you account for any variations in mean returns (or sequence of returns) in your modeling?
This model doesn’t account for variations in return and isn’t meant to. Rather than projecting returns, we’re really only projecting inflation, and to a certain extent tax brackets as we need to have an idea of the gross withdrawal. This spreadsheet works BACKWARD into the return, using an internal rate of return calculation to determine the portfolio return necessary to sustain the distributions. So, if we’re running the plan for thirty years, and we assume 4% inflation and say a $40,000 distribution in year 1 from a $1 million dollar portfolio, we end up knowing what are average return would NEED to be for the portfolio to last that long, in this example, 4.93%. Then, using that, we can derive what our target portfolio balance should be each year after earning that return and taking the distribution, and calculate the withdrawal %. Then, when we go back at the end of the year and see how the real numbers fit with these projections, we know if we need to adjust the policy. I’ve been using +/-10% of the target withdrawal rate as my trigger.
Still a work in progress, too, I’d love to be able to back test it in some meaningful way. So, to answer your actual question, we know that our IRR calc (in the example 4.93%) won’t be a real number – the real return will be all over the map. However, if it is, we only care if it throws our target withdrawal rate out of whack by 10% or more. The spreadsheet actually produces a chart that looks like a curved road, with the centerline being the perfect projection and the boundaries being the 10% +/-. So when we plot the actual WD rate every year, we need to be “on the road.”
William, I could try to send you an example spreadsheet if you’d like to see it. It’s and Excel file. Send me an email at [email protected] and I’ll send it back as an attachment.
I did read Jon’s original article on the subject but I am glad that you have dusted it off. For years, I have been discussing the use of a cash flow reserve strategy that is designed to protect clients who are taking distributions from their investment accounts during down or bear markets. I haven’t (yet) put it in writing. However, your post makes a compelling argument to do so and to codify things in a bit more detail so that it can be given to a client who can pull it out during those periods when the stock market is going haywire and the media is predicting “doomsday.” Thanks for the though provoking post.
I like this. Why have a compass in hand only when heading north? Would a couple only anticipate and discuss how they will handle for richer, awesome rosey days and expect to have a long and fruitful marriage – NO – planning and communicating how one will tend to handle both ends of a spectrum helps us stay on track in multiple areas of life. I have often wondered whether I am taking “too much” this year or whether I could and should “take more” another year. Applause on this idea!
I realize this site is not aimed at people like me who only manage their personal portfolio. Nonetheless, I love this concept and have spent considerable time writing my own WPS. While my ‘rules’ had been set, I expanded and tweaked them so that both my husband and I have written down what we have agreed to. One reason I’m a DIY money manager, is I’ve been pitched annuities many times even when I say I have a strong bias against them. I was happy to read the blog on annuities vs. the safe-floor method.
Susan