Cash Wedge and Opening the Investment Taps
A “cash wedge” is what Daryl Diamond, financial planner, author, educator and respected financial professional on all-things retirement money management calls the income delivery process. Daryl Diamond should know a thing or two about the “cash wedge”, Daryl is largely responsible for the concept, a process dedicated to helping retirees reconcile their income needs to fund their lifestyle objectives securely.
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.
This is where the “cash wedge” process can really help. 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. Because you’re always drawing income from the “cash wedge”, you’ve bought yourself time to weather stock market volatility. Daryl calls this “withdrawal math” and I like his concept.
Daryl on the “cash wedge”:
“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 is eroded and that makes it very hard for the portfolio to recover when markets turn back up again. The Cash Wedge Strategy© can assist in minimizing the impact of withdrawing income during volatile markets. Making withdrawals from investments that are volatile can significantly impact your portfolio. Instead, consider adding a Cash Wedge to your portfolio composition so that retirement income is drawn from a more stable source.”
The wedge is largely constructed like this:
- Year 1 – a small portion of your retirement portfolio is used for income withdrawals; money is allocated to a conservative, highly accessible investment such as a money market fund or savings account. This is the bucket where you draw your retirement income from.
- Years 2 and 3 – a 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. On maturity, these investments are used to replenish the retirement income bucket you’ll withdraw from (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.
More details – year 1
Keep 1-years’ worth of cash inside a savings account. Earn 1-3% on money saved. Keep it liquid. Keep it simple.
More details – years 2-3 – consider a GIC-Ladder
- Divide your savings into 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.
More details – year 4+
Put the rest of your portfolio in equities. Continue to buy low and stay invested throughout. This will increase your chances in riding out any multi-year stock market meltdown.
Opening the investment taps
The “cash wedge” process is very sound and I will probably implement a derivative of this at some point in semi-retirement.
So, for less maintenance I will likely do something like the following:
- Treat any income from our pensions like it is: fixed-income. I will try to ensure this fixed-income allocation is about 30% of our total portfolio. If we cannot meet this criterion I will use whatever portion of our personal investments to get this fixed-income allocation. It is my expectation that (eventually) most of our fixed-income via workplace pensions will pay for basic retirement expenses (all food, all shelter and all clothing) in our 60s and beyond. Before those years, we’ll rely on our portfolio, particularly dividend income to cover our day-to-day expenses.
- I intend to keep about one-years’ worth of retirement living expenses (about $50,000) in cash savings. This portion is really not up for debate. I believe such cash savings will be good to help ride out any short-term market storm and/or cover any cash emergency situation without doing into debt.
- After $50,000 is tucked away in cash I will likely create the following as part of my equity income stream:
- Keep 50% equities 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.
- Keep 50% equities invested in a couple of 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.
An improved asset allocation goal of ours is to keep about 50% U.S. (and any international assets) and 50% Canadian assets in semi-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.
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 the “cash wedge” process as my starting point, my hope is to layer our income delivery process to cover basic living expenses and structure the rest of our portfolio for steady income and growth.
What are your thoughts on the cash wedge? Will you use a similar strategy? Retirees – how are you managing your cash flow?
Image courtesy of http://www.diamondretirement.com/strategies