The success of a retirement income plan is heavily weighted by how you answer the following question: “How will lifetime income be generated?” The Portfolio Waterfall planning process identifies investments that produce cash flow as an economic engine. To be more specific, I’m defining an economic engine as “a system or investment unit that requires an input (capital as a fuel) to provide a possible economic output (appreciation and/or cash flow).”
The most common economic engines are social security, pensions, income annuities, mutual funds, ETFs, and rental properties. Each of these economic engines has unique characteristics, providing investment advisors an opportunity to align the cash flow from these economic engines to help achieve our client’s retirement goals. The philosophy of the Portfolio Waterfall is to satisfy a client’s retirement income generated by working to optimize assets without liquidating units identified as economic engines. The goal is to produce this cash flow while working to minimize risk and maintaining tax-awareness.
When creating a retirement income plan, client expenses can be summarized by two broad categories: those expenses that are paid monthly and those that occur annually. Monthly expenses in retirement are typically stable and rise with inflation over time. Annual retirement expenses tend to change dramatically each year. For example, annual expenses will change as they transition through different retirement phases. From year to year, clients often have a significant variation in expenses due to major purchases, vacations, or healthcare costs.
After determining a client’s monthly and annual expenses, it’s time to determine what type of economic engines should be used to satisfy each type of expense. I believe it makes sense to use relatively steady sources of lifetime income sources to pay for a client’s essential monthly expenses. This provides stability for the overall income plan, giving our clients more peace of mind knowing they will likely not outlive the income needed to pay their monthly essential expenses. The economic engines often used for monthly expenses are social security, pensions, and income annuities.
Once lifetime income is established to pay for clients’ monthly essential expenses, we need to identify the economic engines to be used to pay for their annual expenses. Most commonly, these economic engines are investable assets – typically made up of brokerage accounts, IRAs, or rental properties. The objective is to satisfy a client’s lifetime annual income need, generating the income from the smallest amount of investable assets. This is where the Portfolio Waterfall income strategies are implemented. The economic engines of the Portfolio Waterfall income models are units of mutual funds and ETFs. These units create cash flows that are harvested and pooled within the account for withdrawals.
The key point is that we are collecting cash flows and attempt to avoid liquidating the units we identify as economic engines.
If we agree that the success of a retirement income plan is heavily weighed by how lifetime income is generated, then we must challenge common practices used in the industry. Traditional retirement income strategies liquidate units (economic engines) to provide retirement income. When units of mutual funds or ETFs are liquidated for income, sequence-of-returns risk potentially increases and limits potential income withdrawals.
The good news is, as Investment Advisor Representatives, we can help clients implement a retirement income plan that focuses on the importance of preserving economic engines. When clients see the value of preserving economic engines, it helps them potentially stay invested during periods of market volatility and have more confidence in the overall retirement income plan.
To learn how to implement the Portfolio Waterfall income strategies into your business, please contact TLG Investment Advisor Representative, Josh Curtis.
