Cash Wedge and Opening the Investment Taps
The way I see it, most retirees will need to withdraw capital from their investment portfolios and take advantage of government programs like the Canada Pension Plan (CPP) and Old Age Security (OAS) for retirement expenses to survive.
For many retirees withdrawing from their capital should be a major concern for them: due to longevity risk, inflation risk and financial risk/sequence of returns risk.
This is where the cash wedge can really help.
What is a cash wedge?
How can any cash wedge approach help you?
What do I intend to do?
Cash Wedge Concepts
You already know that investing in the stock and bond market can grow your portfolio during your asset accumulation years. In your withdrawal years however you need to be careful. When equities are up and down it makes a HUGE difference when you draw-down the investments in your portfolio.
This is where any potential cash wedge approach comes in.
Daryl Diamond, a financial planner and leader in Canada on retirement income planning, has a Cash Wedge Strategy©
Daryl on his form of a cash wedge:
“When markets are volatile, it makes a big difference whether you are adding assets or withdrawing assets from your portfolio. When left intact to grow for the long term, the order of the returns on your investments will not affect your portfolio’s long-term average growth rate. This is ‘accumulation math.’ But ‘withdrawal math’ works very differently. When you begin to take income from your investments, the order of the annual returns on your investments makes a big difference. If returns are low in the initial years, the capital base may be eroded and that makes it very hard for the portfolio to recover when markets turn back up again.
Making withdrawals from investments that are volatile can significantly impact your portfolio. Instead, consider adding The Cash Wedge© to your portfolio composition so that retirement income is drawn from a more stable source.”
I like the concept.
Traditional Cash Wedge Construction
The cash wedge is typically constructed like this:
- Year 1 – a small portion of your retirement portfolio is used for income withdrawals; money is allocated to a conservative but highly accessible mix of cash or money market funds. This is the bucket where you draw your retirement income from if you need it for a year.
- Years 2 and 3 – another portion of your retirement portfolio is allocated into a guaranteed short-term investment, such as a 1-2 year Guaranteed Investment Certificate (GIC), some bonds or some fixed-income funds. It could also be cash as you wish. On maturity when using GICs, these investments are used to replenish the retirement income bucket you’ll withdraw from (i.e., Year 1).
- Years 4+ – the rest of your portfolio is left to grow, as a diversified equity portfolio, providing growth for future years and to fund the early-year buckets. Maybe by then, the equity markets have rebounded a bit.
Source/Reference: Diamond Retirement Income Planning.
How to implement your cash wedge?
Consider your portfolio in buckets.
“Bucketing” your portfolio means essentially dividing it into three main investment time horizons above:
- A short-term bucket (say 1-year)
- A medium-term bucket (say 2 or 3 years)
- A long-term bucket (say 4 or 5+ years)
Your goal with your buckets is to insulate the long-term bucket from any major draw down needs, therefore allowing this bucket (think equities/stocks) to remain invested through market ups-and-downs and grow more with time.
Because annual retirement income is drawn from the short-term bucket, for the most part, it holds accessible assets or just plain ol’ cash in reserve for a few years.
So, annual retirement income is drawn from the short-term bucket, periodically topped up from the medium bucket, with finally money strategically withdrawn from the long-term bucket to funnel down.
Based on Daryl’s approach:
“On maturity, the short-term investments are used to replenish The Cash Wedge© and provide guaranteed income for years two and three respectively. The rest of your savings is left to grow with time in a diversified portfolio that meets your personal financial needs. Over time, any profits are moved from the invested portfolio into a cash position to create income for year four and subsequent years.”
How to implement your cash wedge using a GIC-Ladder
You can implement your cash wedge using GICs although that’s not a must.
To do so, divide your savings into two (2) or more separate GICs. Terms can range from 1-5 years. Every year, one of your GICs will mature. Take that money and put it into another GIC term.
Here is an example of a 5-year ladder courtesy of Tangerine:
By doing this, you spread your savings across different terms WHILE minimizing your exposure to interest rate changes. With some GICs maturing every year, you can spend this if you need to and keep investing in equities instead.
Other cash wedge approaches?
I believe the cash wedge process is sound overall but I will probably implement a derivative of this approach, for less maintenance. I am likely to implement something like the following:
1. Treat any income from our pensions like it is: fixed-income. I will try to ensure this fixed-income allocation is about 20% or so of our total portfolio. If we cannot meet this criterion I may use whatever portion of our personal investments to get this fixed-income allocation including some cash. I hope to enter semi-retirement with some sort of bias to equities but I might need some fixed-income just in case to avoid any sequence of returns risk.
Also called sequence risk, recall sequence of returns risk is the risk that comes from the order in which your investment returns occur. To put it another way, there is a major risk that the stock market declines in the early years of your retirement. If you couple that with ongoing portfolio withdrawals and/or major spikes in inflation, that could significantly reduce the longevity of a portfolio and destroy your retirement dreams.
I hope to avoid that.
Unless I take my commuted pension value, it is my expectation that (eventually) most of our fixed-income via workplace pensions will pay for many basic retirement expenses.
Before any pension years, we’ll rely on our portfolio, particularly dividend income to cover many day-to-day expenses.
2. I intend to keep about one-years’ worth of retirement living expenses (about $50,000) in cash savings – that’s my cash wedge. This portion is really not up for debate. I believe such cash savings will be good enabler to help ride out any short-term market storm and/or cover any cash emergency situation without doing into debt.
My cash wedge strategy is essentially cash savings set aside – that separates my stocks (including my dividend paying stocks) from cash savings. We consider our cash wedge like a piece of pie from an entire set of stocks/equities. Instead of bonds or bond ETFs, as our cash wedge it will be just cash – no bond volatility to worry about and far more liquid. At any time, if I don’t chose to “live off dividends or distributions” I could withdraw cash from my cash savings – for market safety.
Worse case, while in semi-retirement, I could spend this cash without ever touching my portfolio value for a year or so. I figure with part-time work in retirement, that gives me about 1-2 years of cash wedge cushion.
3. After our cash wedge/cash savings is tucked away my key retirement income streams will be:
- Income from Canadian and U.S. stocks. I figure $500,000 invested (if we can get there?) should generate at least $20,000 in dividend income per year without touching the capital for life.
- Income from low-cost, diversified, equity or dividend ETFs that invest in hundreds (or thousands) of stocks from around the world. Again, I figure about $500,000 invested in such ETFs will provide extra diversification. We will spend the distributions from these investments in the early years of retirement.
Once all debt is gone and the income generated from our portfolio is consistently higher than our expenses then we’ll probably stop working full time.
Essentially, a cash wedge can be any combination of the following in my book:
- A cash wedge of cash savings and little bonds or no other fixed income.
- A cash wedge of cash savings, some fixed income in the form of bonds or Guaranteed Investment Certificates (GICs), and/or
- A cash wedge of cash savings, GICs, bond ETFs or simply bonds as part of a balanced portfolio (of stocks and bonds).
Either way, you can see a common denominator of the cash wedge approach is simply to have some cash savings in retirement for any “what ifs” in life.
What about Canada Pension Plan (CPP) and Old Age Security (OAS) benefits?
I figure any income from government programs is a bonus for us in our 60s.
CPP and OAS money will be used as a hedge against major spikes in inflation. Conversely, we might draw down our RRSPs sooner than later and defer CPP and OAS until later in life. Time will tell!
There are a number of retirement strategies to consider and I’m sure my approach to prepare for retirement will change. For now, using a modified cash wedge approach is my starting point.
What are your thoughts on the cash wedge? Will you use a similar strategy? Retirees – how are you managing your cash flow?