Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have probably heard about the importance of having an investment policy statement, but they may be less familiar with a withdrawal policy statement.
Joining me to discuss why you might need one is Michael Kitces, a financial-planning expert. Michael, thank you so much for being here.
Michael Kitces: Great to be here again today.
Benz: Michael, you've got a great blog post on your website about withdrawal policy statements. People have heard about investment policy statements. I'd like to just start by doing a little stage setting. Why do we need policy statements for our portfolio and investment plans at all?
Kitces: To me the idea of policy statements at the most basic level is we're trying to come up with a framework about how we're going to deal with uncertain futures. I don't know everything that's coming down the road; I don't know what it's going to look like. It's really hard for us to react to everything that comes at us from life in real time because we get emotional and these are challenging times. And of course, it only matters when things are often more stressful and most difficult.
The whole concept of policy statements to me at the most basic level is having this framework about how we're going to deal with an uncertain future. Investment policy statements may say things like here are the parameters about how much we can adjust the portfolio, and which ways we can adjust it, and what kinds of investments we can own, and what kinds of investments we can't own. So at least we got a framework that as an investment manager is executing on an investment plan in the future, they know the rules of the game. They know how this is going to be played; they know what they're allowed to do and what they're not allowed to do.
To me the idea of a withdrawal policy statement functions in a very similar manner, except what we're doing with it in this case is that it's not necessarily for an investment manager who is managing the portfolio to know what the rules are and how to handle things. It's for us, or for our clients as retirees in our case, about how they are going to handle some of these uncertain futures. And so, its things like how will we handle market volatility with our spending? How much of a decline requires a spending cut? How much of a decline is actually OK? How much can markets go up before we can raise our spending? How much can markets go up where we just kind of stay where we are?
So, the idea is, if we set a series of policies and series of rules about that, then we know how to handle the situations when they come up, and we don't have to make what are often difficult decisions in real time.
Benz: You won't be making [decisions] on-the-fly, and it sounds like if you have taken the time to document what you are doing, you're maybe less likely to override it in the heat of the moment?
Kitces: Yes. That's part of the idea, as well. When we write down things, and we commit to them, it tends to make us a little bit more comfortable in sticking with them. To me in the truer sense, the real purpose of having a plan is kind of literally we know what we're going to execute on as we go. Plans can shift and change over time, and to me that's why we have policy statements, as well. So the plan is, "Well, here is what we're going to do if everything goes well, and maybe we can have a couple of contingency scenarios."
A policy statement sets a higher level that just says on an ongoing basis, "Here is how we're going to continue to execute that if and when and as plans change because life changes when circumstances change."
Benz: It's shaping up as kind of a best practice in the withdrawal-rate area that you should be flexible, and you should be willing to change with the times as your portfolio balance dictates?
Kitces: Absolutely. I mean, what we're seeing a lot in just the retirement research space in essence is the survivability of your spending plan retirement goes a lot better with even just a little bit of flexibility. So, it's prudent from just the longevity of the portfolio, as well as I think just being good practices for how we deal with stressful situations--and not just in terms of how much do I need to change my spending to get back on track at problems like that can arise, but also frankly, recognizing what are events that are actually nonevents and don't need to impact my spending at all.
One of the nice things about having a policy that kind of defines the line of what matters and what doesn't is, like truly, now you know what matters and now you know what doesn't.
[For example, if] the market were off 3%, you don't need to worry. The market actually has to go down 12% to hit this threshold in my policy statement. So once we know what that looks like and we know what the rules of the game are, it makes it much easier to navigate.
Benz: For people who want to take this step and create a withdrawal policy statement, you've got a downloadable form on your website that people can use to go through this work. You've got some key things that you think belong on the investor's withdraw policy statement. One is income goals on a year-to-year basis; another is client assets to which this withdrawal policy statement applies. So, assuming, like, you want to segregate some assets...
Kitces: Yes, in case there's something that's segregated for college. It's sort of like at the high level, we break this into two categories. First is just sort, let's set what we're working with. So what income we all will be working with, what assets are actually available? Let's just make sure--particularly if you're doing this, like with an advisor--let's just make sure we're all on the same page about what we're shooting for in the first place. Like, here is the income goal we're trying to fund. Here is the time horizon we're trying to fund it for. Here are the actual assets we have available. Let's just make sure this is all down and in print, so we are all on the same page.
Then we start to move into, what I think is the meatier portion of the withdrawal policy statement which are things like, what is our actual liquidation strategy going to be? How are we going to draw money? We're going to take interest in dividends and not reinvest them. So you use that cash initially. We will spend those, then to the extent that we need more, we will draw on stocks if they are up. We will draw on bonds if stocks are down. So, we can set a series of rules that looks at how exactly are liquidations going to come out of this portfolio. What truly is the strategy that we're going to execute on?
And obviously we can set up nice rules like, I'll spend from stocks if they're up, but I'll draw from bonds if stocks are down, so I don't have to liquidate stocks in a down market. So we can establish a lot of that framework in advance, so we know where the money is coming from and we know how we're going to pursue this.
Benz: There are a lot of variables that you just talked about. There is a lot going on there.
Kitces: Yes. There are a lot of pieces that we can put into this. Again, so we're just trying to get to a point where I know exactly where my money is coming from or at least how my money is going to get generated on an ongoing basis because that's a concern we see for a lot of retirees. There's nothing intuitive, I think, for us as human beings about I've got this portfolio that's going to generate a total return that includes interest and dividends and capital gains and, oh, by the way, there's qualified dividends and nonqualified dividends. And there's taxable interest and nontaxable interest. And the gains go up and down. And then there are principal liquidations swelling. There are just so many different things. There's nothing really intuitive like, so how much of that am I supposed to spend and what's safe?
To me, that was the origin of the safe withdrawal rate research was trying to close that gap a little. So a withdrawal policy statement just goes further to say how exactly mechanically are we going to go about this so we can be a little bit more comfortable knowing where our money is going to be coming from?
Then the last piece of it, which I think ultimately is really the most important in the long run is, is how are we going to manage this on an ongoing basis? So we said where we are going to draw the money from, but the other piece is how is our spending going to transition on an ongoing basis? So, a good example about how to do this actually comes from the person who first put withdrawal policy statements on my radar screen was, a planner up in the Minneapolis area named Jon Guyton, who has done a lot of creative work in this space and was actually one of the first people that did studies in the Journal of Financial Planning 10 years ago looking at more flexible spending patterns.
So he had set this up as a series of what he called time-decision rules, and now he embodies those into a withdrawal policy statement--and that's the sample we actually have on our website--where he looks at things like if the portfolio is up, you're going to raise your standard of living for inflation. If the portfolio is down, you're actually not going to take an inflation adjustment. It's like a very small haircut in real spending, just to help keep you on track, kind of like at work.
Your company doesn't make a profit; people don't get cost of living raises for the year. Your portfolio doesn't make a profit; you don't take your cost of living raise for the year. It's just trying to keep you a little bit more on target.
But the key parts of how Guyton set up his decision rules, he had what he called the prosperity rule and the capital-preservation rule. Think about this like guardrails or like the bumpers on a bowling lane. So, if I roll the ball down the lane of my retirement and things are going smoothly and I'm going right down the middle, I basically don't need to do anything, just keep on spending, adjust for inflation, life's great, everything is going well.
But if the portfolio declines, something really bad happens, and the ball starts veering off to the left, there's a guardrail there in the form of a check to your withdrawal rate that says something like if you started at a 5% withdrawal rate, but you're now at a 6%-plus withdrawal rate because your spending is outpacing your portfolio or worse like you're spending is going up and the portfolio is going down, like you're getting this big gap. If you get a withdrawal rate that starts at 5% and goes to more than 6%, you need to take a 10% spending cut and get yourself back in [the lane]. So basically, you're going to lift the bowling ball, you're going to put it back in the middle of the channel, and now you're going to continue roll forward. So he calls that the capital-preservation rule because we need to preserve capital when things are bad.
He's also got what he calls the prosperity rule, [which reflects movements] in the other direction. I started out spending 5%, but my spending is just increasing from inflation. My portfolio is off to the races because it's been a great bull market. So now what started out as a 5% withdrawal rate is now 4.5%, and then 4%, and then 3.5%. When you get that low, you can take a 10% spending raise, a real-dollar raise, and lift yourself back up. And now, we kind of move the bowling ball back to the middle of the channel from the other end.
So the idea is let's just have a series of rules about how we're going to make adjustments on an ongoing basis. But here to me is where it gets really powerful when you have an approach like this. When you get events like 2008, or even frankly, the massive bull market run that we've had since 2009, these are both tough things for retirees to deal with. What do I do when the market declines 40%? What do I do when the market rallies 180%? When is it time to change my spending up or down, and when should I just ignore it? Frankly, we don't have a lot of cues for this, right? It's like, oh well, the market seems scary and there's a lot of news about it, I guess, I need to cut my spending because we don't really know what else to do.
The idea of the withdrawal policy statement is you actually start getting some really concrete lines so you know exactly where you need to make your spending adjustments. So, if I started spending on my $500,000 portfolio, and I was spending 5%, I can do the math right now and figure out exactly how far that portfolio has to go down before my withdrawal rate goes from 5% to 6% and I need to take a spending cut.
So there is no more of this, "Oh, I'm down 5%, do I need to worry yet? No. Okay, I'm down another 5%, do I need to worry yet? No. Okay, I'm down another 5%, do I need to worry yet? No." It's like we never know when you've crossed the line.
When you have a withdrawal policy statement like this, you know exactly where the line is. We can sit down, and we can do the math. Let's say your portfolio is at $500,000; if it falls below $420,000, you need to do a spending cut. And until we get there, you don't need to do a change. It's like, that's it. If you want to go online and look at your account balance whenever there's market volatility, that's fine. If the number is above $420,000, you don't need to worry because we're still in the channel; if the number is below $420,000, you just make an adjustment.
You still don't need to worry; you just make an adjustment. And we already know what the adjustment is going to be. We made the game plan. It's 10%. We figure out what it's going to be. We could even look now and say if this happens, what things would you change in your spending to do that 10% spending cut? And we could even figure that out upfront.
So the policy leads us to additional plans that we can make to deal with these uncertainties as they go along, but it gets us out of, what, sadly to me, is kind of the traditional approach of just dealing with everything in real time as it goes. And it's really hard to know what's important and what's not. It's like the old "How do you separate the signal from the noise?" problem. This gives you indications about what is a signal versus noise.
Benz: Right. It seems like it will be really helpful tool. I know a lot of our Morningstar.com readers and viewers are obsessed with this topic of withdrawal rates, so this is another tool in their tool kit. Thank you so much.
Kitces: Absolutely. My pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.