For many financial advisors, capital gains are viewed as a liability to the portfolios they manage. Advisors say things like, “Capital gains create taxes without creating wealth.” Or “they’re too unpredictable.” Or, “Capital gains make tax planning harder.” No one likes a surprise tax bill, especially when the tax bill is not accompanied by an increase in the account value. What if capital gains aren’t something to dread, but could potentially provide higher retirement income while also improving client financial behaviors?
As financial advisors, one of our main jobs is to help the client stay invested when market conditions become uncomfortable. Though clients are eager to quote the “buy low, sell high” mantra, in my experience, most clients are easily spooked by market downturns. Even seasoned investors may have to be talked off the edge when volatility strikes.
In the Portfolio Waterfall investment models, cashflows – including capital gains – are redirected to a stable value investment inside the portfolio. To avoid liquidating potentially volatile shares, retirement distributions are taken only from the stable value allocation. And this is where capital gains timing comes into play. Capital gains from mutual funds typically see their greatest flow in a late bull market. In the Portfolio Waterfall, these capital gains are harvested to the stable value allocation for future income. When this influx of capital gains is followed by a market downturn, clients are reassured that the stable value allocation has increased even though the broader market has declined. Having more cash during bear markets helps buffer clients’ nerves, providing the courage to stay invested. Some may even see the market downturn as an opportunity to reinvest from the stable value fund. Who wouldn’t want more of those client calls?
Let’s take a closer look at the timing of capital gains. Though it is impossible to say
definitively when a particular fund will produce a capital gain, there are typically three phases of the market cycle when we would expect to see significant capital gains inside a mutual fund portfolio.
As mentioned above, the highest realized gains and distributions occur in the late phase of a bull market. These gains occur as mutual fund managers trim appreciated positions in response to market rotation. Many advisors underestimate how significant capital gain distributions can be. For example, late in a bull market, it is not uncommon for a $1MM portfolio to generate $100,000 or more of capital gains. In the Portfolio Waterfall strategy, these distributions would pour into the stable value fund to be available for either income withdrawals or reinvestment opportunities later in the market cycle.
While mutual fund managers are usually responsible for capital gains late in a bull market, during early bear markets, investor redemptions may create an additional wave of capital gains. When nervous investors redeem their mutual fund shares, this requires the fund manager to create more cash for share redemption. This, in turn, generates additional capital gains that must be paid out to the remaining shareholders. When these gains are harvested and reallocated to the stable value fund, this reassures retirement clients that the bear market will not prevent them from receiving income as before.
There is typically a third, though less pronounced, wave of capital gains during the recovery phase. Moderate new capital gains are often produced as the growth allocation refills from recovery profits.
When using the Portfolio Waterfall investment strategy, capital gains are not something to be avoided, but they become a key factor driving the success of retirement income portfolios. When capital gains are harvested instead of automatically reinvested, their timing in the market cycle aligns in surprising ways with the income needs of retirement clients. From a behavioral finance perspective, these cashflows reinforce positive client behaviors. In my experience, clients who understand how cashflows occur in their retirement portfolio are more likely to stay invested and worry less, no matter where we are in the market cycle.
If you would like to discuss these ideas in further detail or would like to know how to implement the Portfolio Waterfall investment strategies into your practice, please contact me using the information below.
(402) 249-5747
