1) Buy Securities that Return Cash
There is a wide choice of individual securities and funds that distribute cash on a regular basis, whether monthly, quarterly, semi-annually, annually or once at maturity. The gamut includes: Treasury Bills, Commercial Paper, Provincial and Canada Savings Bonds, Guaranteed Investment Certificates, Real Return Bonds, Government and Corporate Bonds, Common Stocks and Preferred Stocks (see previous post on Investment Building Blocks for more description).
The chart below shows the usual frequency of payment for each type of security. Mutual and exchange traded funds often provide more frequent payment than the underlying security since their collection of securities will typically have staggered and constant incoming cash.
2) Sell Securities as Needed per the Target Asset Allocation
This method entails selling securities that are in excess of the asset allocation (how to create an asset allocation was previously discussed in Asset Allocation: the Most Important Investment Decision You Will Make) set for the portfolio. If bonds are intended to be 40% of the total portfolio value and due to market changes they have gone up to 50%, then there is 10% extra than there should be in bonds and that would be the place to start to generate cash. Such sales dovetail with the re-balancing that should form part of portfolio management.
Which Method to Adopt
There isn't a cut and dried best answer. A number of factors can influence which one, or which mix of the two, an investor should choose:
- time and effort to set up and maintain - figuring out all the incoming cash flows for various cash-generating securities (they will all be unique) may take considerable time initially but once done properly will be more or less automatic and require little attention with occasional reinvestment of matured fixed income securities; the asset allocation method can also be time consuming to set up, depending on how many asset classes are chosen and though the sell becomes fairly mechanical according to the Investment Policy, the sell must be done each time by the investor (though even that is not strictly speaking true since Claymore, amongst ETF providers, and most mutual fund companies will set up a Systematic Withdrawal Plan for their funds, which includes portfolio-type funds)
- taxes - income from a registered plan, such as a RRSP, RRIF, LRIF is always taxed at the highest marginal rate so it doesn't matter whether the cash comes from dividends, interest or capital gains. From a taxable non-registered account, there is a big difference in tax rates - dividends are taxed lowest, then capital gains, then interest. The above chart shows what tax type of revenue each type of security gives off.
- constancy, reliability of cash flows and return vs risk - securities that return cash on a steady guaranteed basis tend to offer lower returns - it's the old story of less risk equals less return. The big question is whether the lower returns will be sufficient to meet needs. For a long retirement, lower returns increases the possibility of running out of funds. To meet a short-term goal, safe and stable securities such as T-bills, GICs and Money Market funds are much wiser than volatile stocks or long-maturity fixed income.
- inflation - most of the fixed income categories, an exception being real return bonds, also offer little protection for unexpected inflation - see force #3 in Investing Principles - Minding the Immutable Forces. Over a long period, such as 20 years in retirement, inflation can drastically reduce buying power
- psychology - while withdrawing the cash arising from interest may be easy, it may be difficult to bring oneself to sell a holding to create cash; there can be more of a feeling that the portfolio is going down, despite the fact that in both cases the same amount of cash is coming out. This can be especially tough to do in current circumstances when many investments have gone down. The oft-noted reluctance of investors to sell losers (e.g. Terrence Odean's classic research paper Are Investors Reluctant to Realize their Losses?) can get in the way.