Based on the response from readers, the withdrawal stage portfolio is a hot topic. And, unfortunately, a topic that most advisors are not really equipped to deal with. 

There are four key requirements within a withdrawal stage portfolio; 1) the portfolio must survive a life time, which is a highly variable time horizon and 2) it must provide for some growth without impinging principal in the early stages (timing of the investment is critical), 3) it must provide a healthy cash flow to deal with early stage withdrawals and 4), you want to manage the cash flow to be as tax efficient as possible. 

If you think about it, the key driver is variability of return. A return of 6% per year each year is preferable to a portfolio with say, a five year return matrix of -5%, 4%, 12%, 12%, 8%, which also compounds out at 6% per annum. Assuming a 6% withdrawal rate and a 3% inflation rate, the non-variable portfolio lasts roughly three years longer than the variable portfolio. 

If the objective is to reduce variability, then investors and advisors must re-think the way they construct portfolios. Easier said than done, given that most have spent a lifetime seeking out products that produce higher returns. 

We reduce risk through diversification, which means blending a cross section of investments that historically, have tended to have low correlations with each other. 

The problem with this approach is that it may run contrary to point 3 above. A portfolio generating strong cash flow, by definition, would include a healthy dose of domestic bonds, treasury bills, GICs, preferred shares and income trusts. 

The problem is that all of these assets are impacted to one degree or another, by changes in interest rates. Holding assets where the main risk factor is interest rate variability, does not a diversified portfolio make. 

If we are to deal with interest rate variability, we generally diversify by adding global bonds to the mix. The cash flow from a global bond typically reflects where a specific region of the world is on the business cycle. 

Of course, utilizing global bonds to reduce interest rate variability, brings currency exposure into the portfolio. Try selling the benefits of that strategy to Canadian investors.

Advisors and investors must also deal with market risk in withdrawal portfolios. Defined in this model as the risk of a discontinued payment stream. The market rarely attaches that risk to government bonds, as it assumes that the regular interest payments will be made and the principal will be repaid at maturity. 

However, the market can raise flags about preferred shares and income trusts. If the market fears a payment interruption, it will quickly extract its pound of flesh from the asset’s price. Just ask anyone holding preferred shares over the past six months.

I manage one income class portfolio, which tries to actively diversify across assets and sectors. We hold treasury bills, government bonds, high quality corporate bonds, preferred shares, and income trusts. Whether by good fortune or pure luck, we have not had serious exposure to foreign currency. But still, the portfolio has been impacted by losses in preferred shares and to a lesser extent, income trusts. 

This takes us to another level of diversification which includes good quality dividend paying common shares and covered call writing strategies. In my model, I have been holding 10% to 15% of the portfolio in cash or cash equivalents, about 40% in Canadian common shares and covered writing strategies, 20% in preferred shares, 20% government bonds and 5% to 10% in income trusts. 

That structure has allowed us to mitigate most of the damage from the sub prime crisis, and the resulting fallout among preferred shares. Particularly beneficial to the portfolio’s bottom line was the results from our covered call writing exposure among shares of energy and precious metals companies. 

From a diversification perspective, option premiums are directly correlated to market risk. Which is to say when risk rises, so to do option premiums. With a covered call writing strategy, we are selling options and receiving the premium.

Interestingly, a number of readers asked why don’t more investors employ covered call writing as a strategy. The answer is that many investors think the strategy is too complex. It is also difficult for individual investors to implement a diversified covered call writing portfolio after accounting for transaction charges, which can erode as much as 20% of the benefit of the strategy. 

More importantly, covered call writing is an equity based strategy which should only be used to complement other strategies within the portfolio. It cannot be the only strategy in a withdrawal portfolio. 

When you add covered call writing to an income model that includes cash, preferred shares, bonds, income trusts and dividend paying common shares, it can do wonders for your bottom line. But again, for the average investor, that level of diversification and the management that goes along with that model, is almost impossible to implement. Suggesting that it is one of those areas where you may want to contact a professional. 

Having said that, there are passive products that provide exposure to each of the asset classes as defined. If you are determined to set up and manage your own withdrawal stage portfolio, here are some suggested securities. 

Cash is an obvious one, where you can employ any number of money market funds or even buy treasury bills. Claymore Investments is expected to launch a money market ETF. For more information on Claymore products go to www.claymoreinvestments.ca.

For the preferred share component there is the Claymore S&P/TSX Preferred share ETF (symbol CPD, listed TSX). Scotia Capital offers some interesting structured preferred share products which can be found at www.scotiamanagedcompanies.com.

For the covered call writing component, take a look at Mulvihill (www.mulvihill.com) which offers the Premium Income fund (symbol PIC.A, listed TSX). This fund writes covered calls on a basket of bank stocks. 

Bonds can be purchased through Barclays iShares (www.ishares.ca), which include the Broad Bond Universe Bond Index fund (symbol XBB, listed TSX). The fund holds a basket of bonds based on the Scotia Capital Bond Universe. If you prefer shorter term bonds, you could opt for the iShares Cdn Scotia Capital Short Bond Index (symbol XSB, listed TSX). 

For dividend paying common shares, consider the iShares Cdn Dividend Index Fund (symbol XDV, listed TSX). This fund holds a basket of dividend paying common shares based on the S&P/TSX Capped Dividends Index. 

For income trusts, there are a number of options including the iShares Cdn Income Trust Sector Index (symbol XTR, listed TSX). Scotia Capital also offers a number of income trust baskets, one being the SCITI Trust (SIN.UN, listed TSX). For more information go to aforementioned Scotia website. Barclays also offers Advantage funds which provide tax advantaged cash flow from income trusts through a structured investment fund (symbol BAI.UN, listed TSX).