Thursday, 25 June 2009

Generating Cash: Asset Allocation with the Global Couch Potato Portfolio

Following on the last post's examination of the High-Yield Couch Potato portfolio example of how to generate cash from a portfolio, this post looks at the asset allocation method using the Global Couch Potato portfolio. The basic idea of the asset allocation method is that the target cash amount is attained by selling whatever amount of securities are required to make up the difference with the interest and dividends received automatically from the investments. This is done simultaneously with sales and/or purchases of all securities in the portfolio as needed to bring the proportions back to the target allocation.

Hypothetical Scenario:
  • $240,000 starting amount invested in a non-registered taxable account
  • $13,000 annual cash to spend as retirement income must be generated
  • fictitious one year market price changes - Global rises to $258,000; arbitrarily chosen to demonstrate how the asset allocation method would work
  • recent actual cash yields of the various ETFs to bring out the differences between the two methods.
Global Portfolio
This portfolio contains three diversified equity ETFs:
  • a broad Canadian market fund (TSX: XIC
  • a broad US market fund traded in Canada (TSX: XSP)
  • a broad fund of Europe, Australasia and the Far East (TSX: XIN) and
  • the same Canadian bond fund XBB
The Global portfolio is estimated to provide $7,536 in dividend and interest cash based on current payouts. The rest of the $13,000 needed would have to come from sale of some of the ETFs. The following chart shows how this is achieved in the course of rebalancing to maintain the target asset allocation in the portfolio at the end of the year. It is a bit of work to figure out how much to buy and sell of each security in the portfolio. But the amount of cash generated will come out exactly to the target amount of $13,000 since the net sale of securities will simply be the difference between the automatic cash received from dividends and interest and the target.

Riskiness - this portfolio is diversified with holdings of companies around the complete developed world so that reduces risk ... somewhat. As the credit and financial crisis showed, the whole world can go down drastically at the same time. Equities are especially prone to swings and this portfolio is 75% equities versus 60% for the High-Yield. That can hurt very much when sales of securities are needed, as in this case, to make up the difference to reach the income target. The portfolio may never recover.

Taxes - the Global portfolio does appreciably better on saving taxes with an average tax rate of only 18% due to a big dose of lower taxed capital gains in its income. The 7% tax rate difference means an extra $700 in the pocket for every $10,000 of income in the Global portfolio and is akin to moving down several income tax brackets.

Inflation - the same comments apply as for the High-Yield portfolio, except that there is less of the bond fund XBB so this portfolio will suffer less from inflation in the long term.

Which portfolio, Global or High-Yield, is best for generating cash? Neither is perfect, as the above discussion shows, and there are many other portfolios that could do well too. The intent of the above is not to be an investment recommendation but to bring out key elements to consider.

A big caveat is that the withdrawal rate of 5.4% ($13k / $240k) is too high to be sustainable and the portfolio would be depleted in 10, 15, 20 years - 4% is the maximum rate (see for example Sherry Cooper's book The New Retirement). The beginning size of the portfolio would have to be $325,000 to sustain 4% withdrawal rates indefinitely (4% of $325k is $13k).

1 comment:

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