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Exit strategy: Why retirees need a withdrawal policy statement

Staying the course in the midst of market volatility is a challenge for any investor—and one that is only exacerbated when it concerns a retiree taking retirement cash-flow distributions.

As 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.

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While there are many strategies to help retirees stay invested, retirement researcher and certified financial planner Jonathan Guyton, principal of Cornerstone Wealth Advisors, suggests that the best approach may be to craft a withdrawal policy statement.

Similar to an investment policy statement, a WPS has three main goals: 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 to determine, in advance, what steps will be taken to keep the plan on track.

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Of course, the reality is that any such changes 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 retirees 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?

WPS defined

The idea of a WPS was first published several years ago by Guyton in the Journal of Financial Planning. The basic concept is that, just as investors might establish an IPS that sets forth the parameters about how investments will be managed on an ongoing basis, the WPS establishes similar parameters—but in the context of how portfolio withdrawals will be implemented to generate retirement cash flows.

And like the IPS, the 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 long-term goals.

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As Guyton explains, a WPS must be broad enough to handle unexpected situations but specific enough to leave little doubt about what to do when those situations arise.

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By analogy, think of rebalancing a portfolio: While investors could simply choose to buy more equities when the market is down, that can be a very difficult tactic to implement in the heat of the moment.

When there is a policy that already stipulates periodic rebalancing in specific circumstances, 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 investors to follow through accordingly.

Key provisions of a WPS

So what exactly would a WPS contain? Guyton suggests that it cover five key areas:

1. The income goals to be met via withdrawals.
2. The 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.
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 areas would normally be articulated in a financial plan already, and the third item—the initial withdrawal rate that will be used to set the retiree's target spending floor—is relatively straightforward to set without a policy statement. The real keys are the fourth and fifth items, which truly establish a "plan" for how the retirement cash flows will be funded, implementedand adjusted as circumstances unfold.

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

Similarly, the fifth 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. In addition, the current withdrawal rate will be continuously monitored where spending is cut if the current withdrawal rate rises more than 20 percent from where it started (e.g., rising above 6 percent if it started at 5 percent percent initially), and spending can be boosted if the current withdrawal rate falls by more than 20 percent from its origin (e.g., falling below 4 percent after starting at 5 percent).

Practical implications of planning

As noted earlier, the reality is that any of these strategies could simply be decided on the spot rather than being articulated up front in a WPS. There's nothing necessarily different about what is going to be done, simply because it's detailed 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—which risks derailing long-term goals even further (e.g., selling out of markets entirely in the midst of a decline).

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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 IPS— what investment changes may or may not be implemented in response.

In other words, just planning to make adjustments if/when/as the markets do whatever they do is not actually a plan, but having a WPS to follow actually is a real, actionable and implementable plan.

At the end of the day, having a WPS is about managing behavior. From that perspective, it 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 when it is not.

Automatic adjustments

By way of example: A retiree's $1,050,000 portfolio plummets sharply to $930,000, which might be terrifying in the absence of any other guidance. But if the retiree was spending $55,000 annually, then the reality is, the withdrawal rate simply went from 5.2 percent to 5.9 percent. As the WPS has already stipulated that no action need be taken until the withdrawal rate exceeds 6 percent, the retiree doesn't need to worry until the portfolio falls below $916,000.

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Even at that point, there's still no real worry, because the action plan has already been set: Spending will be cut by 10 percent if the current withdrawal rate rises above 6 percent. The retiree could even plan out in advance what particular spending will be cut if that 10 percent adjustment must take place.

Compared to what otherwise is the terrifying uncertainty of questions such as "Have I lost too much money?" and "How do I know when to act?" the WPS approach has set forth clear targets about what is not worrisome, what is a decline that's far enough to warrant action, and what is the appropriate action to take to get back on track (while also making it clear that other, more drastic actions, such as bailing out, are unnecessary).

"At the end of the day, having a WPS turns the scary uncertainty of market volatility into a series of clear thresholds and specific steps to take in response."

At the end of the day, having a WPS turns the scary uncertainty of market volatility into a series of clear thresholds and specific 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.

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While it's not guaranteed to take all emotions out of the retirement equation, 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 retirees something to shoot for on the upside.

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

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