Using a Withdrawal Policy Statement for Retirement Income Planning
You have saved steadily throughout your career. You have a Defined Contribution Pension Plan from work, a Locked-In Retirement Account from a previous employer pension, a Registered Retirement Savings Plan, and a Tax-Free Savings Account. You have arrived at the point of retirement. How are you going to draw down those different pots of money? That is the purpose of a Withdrawal Policy Statement (WPS): to define a series of boundaries and guidelines about how your retirement income will be funded from your portfolio of accounts, to set rules for responding to a market downturn, and to decide in advance what steps will be taken to keep the plan on track.
The purpose of the WPS is not to specify goals themselves, but to describe how the withdrawals will be managed so that they align with your long-term goals. As financial planner Jonathan 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.
“Everybody has a plan ’til they get punched in the mouth” – Mike Tyson
Of course, it’s always possible to manage these situations as they happen. But the purpose of the WPS is to set clear procedures about how unexpected situations will be handled. The goal is to reduce uncertainty and make it easier to stick to the plan.
Think of rebalancing in a portfolio; while you could simply choose to buy more equities when the market is down, that can be difficult in practice. When there is a policy that already stipulates periodic rebalancing under certain conditions, the uncertainty of what to do is removed, the default strategy is set, and it’s much easier for you to follow through.
Key Provisions of a Withdrawal Policy Statement
Jon Guyton, who first proposed the idea of a WPS, suggests that the statement cover five key areas:
- The client income goals to be met from withdrawals;
- The client assets to which the WPS applies that will fund those income goals;
- The initial withdrawal rate;
- The method of determining the source of each year’s withdrawal income from the portfolio; and
- 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.
The first two items are often part of a financial plan already, and the initial withdrawal rate is relatively straightforward to set without a policy statement. The real keys are the fourth and fifth items, which establish a plan for how the retirement cash flows will be funded, implemented, and adjusted as necessary.
For instance, the fourth item might prescribe withdrawals from the asset category that is most overweighted. You might have decided that your situation calls for a 50% weighting for equities across your accounts. Because of strong performance, your equities now make up 55% of your portfolio. You would therefore withdraw from your equities first until the percentage had dropped back down to 50%.
The 5th item might specify something like the rules Guyton used in his research on decision-rules-based withdrawal rates. Spending would increase each year by inflation and the current withdrawal rate would be continuously monitored. Spending would be cut if the current withdrawal rate rose more than 20% from where it started (e.g., rising above 6% if it started at 5% initially), and spending could be boosted if the current withdrawal rate fell by more than 20% from its origin (e.g., falling before 4% after starting at 5%).
Practical Implications When Planning for Retirees
While these strategies could be implemented when you are confronted by a need to decide, having a plan in place before decisions have to be made helps retirees respond objectively, which is much more difficult to do when faced with a volatile market. Without a plan, the more likely response would be emotional and quite possibly damage your long-term retirement goals. In other words, a WPS is about taking steps to manage your behaviour by giving you a plan for how to behave in the face of uncertainty.
An Example of a Withdrawal Policy Statement
Suppose you had a $1,000,000 portfolio. Before retirement, you had created a WPS that included the following paragraph:
- You are age 65 in 2021. Based on an expected nominal annual portfolio return of 4.55%, annual inflation of 2%, and an expected lifespan to age 98, you will withdraw 4.29% in the first year of retirement, adjusted upward annually by the rate of inflation.
- If a significant decline in the value of the portfolio occurs, such that the amount of the withdrawal is forecast to exceed 5.15% (20% higher than the target rate), spending will be cut by 10% that year.
- If a significant increase in the value of the portfolio occurs, such that the amount of the withdrawal is forecast to be less than 3.43% (20% lower than the target rate), spending will be increased by 10% that year.
According to this policy statement, 4.29% of a million-dollar portfolio equals a $42,933 withdrawal. If expectations hold, the expected portfolio balance at the beginning of the next year is $1,000,613 and the amount to be withdrawn is $43,792 (2% greater than $42,933).
However, in the scenario for this example, by the end of the second year, the investment return in the portfolio was -20%. While the principal balance was projected to be $1,000,356 and the amount to withdraw would be $44,668 (2% greater than $43,792), the principal for the third year had dropped to $765,457. As a consequence, the projected withdrawal would climb to 5.84% ($44,668 ÷ $765,457). Consequently, you reduce your withdrawal amount by 10%. Subtracting 10% from your target $44,668 means that your withdrawal amount for the coming year is reduced to $40,201 ($44,668 – $4,467).
Fortunately, during the year that you cut back, the market returns a healthy 9%. Nevertheless, 2% above last year’s withdrawal amount, $41,005, is still greater than your upper threshold of 5.15%. You need to reduce the projected withdrawal by 10% again, to $36,905 ($41,005 – $4,100).
Another good year, this time with an 11% portfolio return, means you can resume your 2% annual increase to keep pace with inflation. You withdraw $37,643.
A string of double-digit portfolio returns brings your withdrawal rate below 3.43% of the principal, triggering a 10% increase in the amount you had planned to withdraw. In a year when you had planned to withdraw $40,746, your 10% increase rule means you withdraw $44,820. What’s more, because you had cut back your withdrawals for a few years, you find that your current projections now leave you with more money in your portfolio at age 98, than when you started. You find that for the following year you can withdraw $63,714.
Based on your age of 74 in the year 2030, to spend down your portfolio by age 98, your target withdrawal rate has increased to 5.3% of principal, which is consistent with your annual inflation adjustments. With fewer years left to recover, you tighten your tolerances a bit to 15% above or below your target.
Wouldn’t you know it, in 2023, there is another 20% loss in your portfolio, requiring you to adjust your planned withdrawal downward by 10%. Instead of $67,614, you reduce the figure to $60,853 ($67,614 – $6,761).
A 13% return the next year, though, allows you to take the 2% inflation adjustment, so you withdraw $62,069 and continue adding 2% each year for the next several years.
At the beginning of 2040, you review your projections and see that you might fall short in your final year, so you make a slight adjustment. That year you had planned to withdraw $69,900, but after reviewing the figures, you reduce the withdrawal to $67,147. Thereafter, you continue with your annual 2% inflation adjustments and, despite fluctuations in your returns, you can maintain the increases until your final year at age 98.
Below is a table of the withdrawal history, as described above. To be clear, the portfolio return figures are completely arbitrary. The geometric mean return works out to 4.63%. Note as well that, although 2% has been the Bank of Canada’s long-term inflation target, there is nothing to suggest that Canada’s economy will not have periods of higher or lower inflation over a 34-year history. Withdrawal amounts that have been adjusted due to portfolio losses or gains are highlighted in bold italics.
The Power of Compounding
Another thing to note is the power of compounding. At the beginning of the withdrawal history, you, the retiree, had a $1,000,000 portfolio. Over the next 34 years, the amount withdrawn from the portfolio totaled $2,172,390 on a modest average annual return of under 5%.
When I worked in the discount investment industry, especially after the 2008-2009 crash, I spoke with several clients who decided they had had enough of investing in risky assets that fluctuate in value. Yet, as was the case in this example, a disciplined, planned approach to cut slightly on withdrawals could have been more effective for them. Although major declines in the investment markets can be followed by more major declines, the pattern is more often a so-called “reversion to the mean.” That is, a major drop in prices is often countered by a significant gain, sometimes lasting for years. Similarly, several years of performance above the average means a possible reversion to below-average returns in subsequent years. A plan to review your accounts annually and make appropriate adjustments to your withdrawal schedule as required simply works. A Withdrawal Policy Statement is a prudent response that has the potential to reward you with a steady income in retirement.
The inspiration for this post and some of the material comes from the article: “Crafting a Withdrawal Policy Statement for Retirement Income Distributions,” by Michael Kitces.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.