Portfolio Waterfall – A Unique Distribution Model

Josh Curtis
Clarity Financial

Our clients who are heading into retirement today face many challenges – low interest rates, market volatility, and longevity to name just a few. The question is, are you going to rely on strategies from the past to help your clients in this new challenging environment? I believe in times like these we need to look for new, innovative solutions.

When it comes to retirement income from market portfolios, the common practice has been to reduce market risk by shifting a portion of equity allocations towards fixed income. Then systematic withdrawals are taken equally across the portfolio with annual rebalancing. The biggest drawback of this approach is that clients will likely be limited to withdrawal rates of 3-4% of the portfolio value.

Another common practice is to segment clients’ retirement assets into different time frames using the bucket strategy. This approach is helpful in keeping clients invested during volatile markets, but it still has limited withdrawal rates and a similar sequence-of-returns risk as the previous strategy.

Over the last several years, I have been searching for a new income model to deliver higher potential withdrawal rates, reduce sequence-of-returns risk, and help clients stay invested during volatile markets. Throughout this journey, I uncovered what I call the Portfolio Waterfall model. The concept is to have money “waterfall” through the portfolio at all times. At the bottom of the waterfall is a pool for retirement income. Having money flow across growth, growth and income, alternatives, and core bond allocations may not sound innovative at first. However, I have discovered that new efficiency is created when income and capital gains waterfall into a safe reserve for withdrawals. This efficiency allows for higher withdrawal rates with less sequence-of-returns risk. Over time, we also see an increased internal rate of return when compared to traditional withdrawal methods. After discovering this efficiency, I reached out to one of our fund managers to have their CFA’s review the model. Their analysis confirmed this newfound efficiency and the fundamentals of the Portfolio Waterfall model. In contrast to the traditional theory of reinvesting capital gains and income while taking withdrawals equally across the portfolio, the Waterfall model keeps those gains safe from market risks by having them flow down into a safe pool for income withdrawals. Securing the income and capital gains significantly reduces the sequence-of-returns risk, creating the potential for higher income withdrawals from the portfolio. The moral of the story is this. When money waterfalls through a portfolio it brings new life in the form of higher potential withdrawals and an increased internal rate of return, and it does this without increasing downside market exposure.

I have seen the internal rate of return increase by as much as 24% when compared to traditional withdrawal strategies using the same funds, the same allocations, the same income withdrawals over the same ten-year period. Having the proper number of holdings and allocations across the Portfolio Waterfall model is key to its success. The alternative allocation is another significant part of the Portfolio Waterfall model. The job of the alternative allocation is to smooth out market volatility and create more consistent returns which are, hopefully, higher than current high-quality bond fund yields with less duration risk.

While portfolio allocation and fund selection are important, the Portfolio Waterfall model demonstrates that how you take withdrawals out of a portfolio can be just as, if not more, important to the success of our clients’ retirement income. More information on how to implement the Portfolio Waterfall model will be coming out soon.