The Yield Shield: Putting it all Together

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
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Today we will be concluding our multi-part series on the Yield Shield. Over the past few weeks we wrote about all the parts that make up the Yield Shield, namely:

  1. Preferred Shares
  2. Real Estate Investment Trusts (REITs)
  3. Corporate/High Yield Bonds
  4. Dividend Stocks

And throughout it all, people have been emailing me asking “Yeah that’s great, but how do I put it all together to assemble my own Yield Shield?” So today we’re going to be talking about exactly that.

It’s All About Pivoting

Building a Yield Shield isn’t hard. It’s simply a matter of taking your existing low-cost indexed portfolio and pivoting a portion of your assets towards the higher-yielding versions that we talked about. To do this, we have to answer two questions:

Q1: Which assets do we pivot? And for what?

I’ve alluded to this in those previous articles, but generally you want to match up the higher-yielding assets with the ones that are the most similar in nature to avoid swinging your portfolio’s risk/return characteristics too much. For example, if you decided to add more REITs, but you swapped your bonds out for it, you’ve fundamentally changed your portfolio’s equity/fixed income mix, and that’s probably not what you intended. For the higher-yielding assets we’ve discussed, your swaps generally should look like this:

Bonds –> Corporate Bonds, Preferred Shares

Swapping your regular bonds for Corporate Bonds or Preferred Shares doesn’t fundamentally change your equity/fixed income allocation, since Corporate Bonds are still bonds, and Preferred Shares act more like bonds than equities. In fact, if your bond allocation is in a Total Bond Market Index of some sort, it likely already owns Corporate Bonds. By doing this swap, you’re just pushing your bond allocation’s credit rating towards the BBB end, so you’re not doing anything too crazy. Generally, this swap will increase your portfolio volatility, but your yield will go higher.

Domestic Equities –> Dividend Stocks, REITs

Like the above swap, swapping the Domestic Equity Index for Dividend Stocks is not too different, since the Index itself owns Dividend-producing stocks. This will, however, pivot your allocation more towards bigger, established companies in saturated marketplaces like Coca-Cola and Johnson & Johnson, and away from smaller high-growth stocks that will tend to return their value as long-term capital gains. If you’re building your Yield Shield, this is a good trade-off. Similarly, pivoting towards REITs is a bit like owning the building those companies are in rather than the company itself. You’ll get more steady month-to-month income, but you won’t participate as much in those companies’ success.

International Equities –> International Dividend Stocks, REITs

Because a significant portion of our portfolio is in International Equities (US, EAFE, Emerging), I could theoretically find similar International Dividend Stock ETFs and International REITs to swap for yield as well. The reason I haven’t done that is because I don’t like depending too much on international yield. When you stick with bonds and stocks of your home country, you know exactly how much yield you’re going to make. But when that yield comes from other countries, you’re going to get that yield in a foreign currency, and if that foreign currency swings in value relative to your home currency, you may not be getting as much money as you thought. That being said, just because I haven’t done it myself doesn’t mean you can’t (or shouldn’t), so if you’re up for it this is another worthwhile swap to consider.

Q2: How much of each asset should I pivot?

The short answer is: As much as you need. And for a longer example, let’s do an example, shall we?

The Canadian Workshop Portfolio

For our example Yield Shield exercise, let’s start with the Canadian portfolio we used for our Investment Workshop series. If you’ll recall, our Canadian portfolio was this:

 

Great. Super. Now what’s the yield on this portfolio? To find that, we have to go to each ETF’s prospectus and pull out the current yield on each one. Then we have to calculate a total portfolio yield by multiplying the weighting on each asset by its yield, and then adding it all up, like so.

2.3%. Not bad, but we can do better. Let’s add in our higher yielding assets and their respective yields (shaded in grey).

And now it’s a matter of playing around with the weighting in Excel until you arrive at a weighting that you’re comfortable with that gets you the yield you need. For us, we’ve decided to aggressively pivot into higher-yielding assets because in our early-retirement phase, we need the yield more than we need the capital growth. Right now, we are sitting around here:

So to recap, I’ve decided to pivot the majority (75%) of my fixed income towards higher-yielding fixed-income assets. I’ve also decided to pivot half of my domestic equity towards Dividend Stocks and REITs. International equities I’ve left alone.

Doing this has allowed me to raise me 2.3% portfolio yield almost a full percentage point to 3.0%.

The American Workshop Portfolio

Now let’s do this again for our American portfolio as featured in our Investment Workshop. To recap, here is our American portfolio.

So what is our portfolio yield? Like before, we need to go to each ETF’s prospectus and grab the most recent yield numbers. Here they are.

 

So our American portfolio is also yielding around 2.6%. Super. Well, let’s see what happens when we add in the higher-yielding assets we’ve been discussing.

 

Phew. There are some real juicy swaps to be made here, right? Specifically, the 5.5% yielding Preferred Index vs the 3% yielding Total Bond Market index. Plus the 4.4% yielding REITs vs the 1.8% yielding US equities. In finance terms, this is what we would call a “spread.” And a fairly attractive one at that.

Now, while the above Canadian portfolio is basically the portfolio I’m invested in now, this US one is purely hypothetical. This is what I, personally, would do if I were an early retiree in the US, but this should not be misconstrued as financial advice. I don’t know your personal financial situation, and you should, as always, do your own research!

But as an example for you to work off of, here’s my hypothetical US Yield Shield portfolio.

The US portfolio could potentially yield even higher than my current Canadian one, owing to the fact that my restriction on only swapping out domestic equities means a LOT more room to maneuver on the US portfolio than the Canadian portfolio. Personally, I have a bit of mistrust in pivoting my international equity towards yield because of foreign exchange risk, but if you’re more comfortable with that than I am, you could potentially increase your yield even more!

The Yield Shield and Your Cash Cushion

So why is this all important? Because all of this affects your Cash Cushion.

Recall that the first two lines of defense when guarding against an unexpected market crash in early retirement are:

  1. The Yield Shield
  2. The Cash Cushion

The Cash Cushion is the amount of cash you hold to finance short-term expenses. But its’ second job is to provide a way to prevent you from selling assets during a market downturn. Remember that even when markets fall, your Yield Shield still does its job of giving you income. So in reality, your cash cushion only needs to cover the gap between your expenses and your yield. If your expenses were $40k, and your portfolio of $1M was yielding 2.5%, your yearly gap would be:

$40k – $1M x 2.5% = $15k

In other words, you would need to keep a Cash Cushion of $15k for each year of Cushion you wanted. To keep 3 years of Cushion, you’d need $45k. To keep 5 years, $75k.

But if you increase your yield by using the Yield Shield techniques I’ve outlined above, you can get away with way way less in your Cash Cushion. Let’s take the American portfolio, now yielding 3.4%. With a 3.4% yield on a $1M portfolio, and with living expenses of $40k, your yearly gap would be:

$40k – $1M x 3.4% = $6k

Now, you only need $6k of Cash Cushion to cover one years, so a 3 year Cushion would be only $18k, and a 5 year Cushion would be $30k.

This is the power of the Yield Shield. The higher your Yield Shield, the less money you need to keep outside your portfolio. And theoretically, once your Yield Shield covers 100% of your living expenses, you don’t need to keep a Cash Cushion at ALL.

Lowering Your Yield Shield

That being said, don’t think that a Yield Shield is meant to be permanent. It’s not. Creating a Yield Shield distorts your portfolio from a pure indexing strategy, which I (and many FI bloggers) believe to be the only investing strategy that consistently works long-term. The purpose of a Yield Shield is to guard against the sequence-of-return risks that threatens every early retiree.

A pure indexer would get screwed if they retired during a financial meltdown. But someone who implemented a Yield Shield during would have come out unscathed.

But remember this: You don’t need to do this during the accumulation phase. You only need to raise the Yield Shield after you retire. Also, this is meant to be temporary. It increases portfolio volatility, and increases investment fees (since many of these smaller funds that track REITs and such have higher MERs), so these aren’t investments that you should stay in long term.

I’m not planning to either. As our retirement continues to cruise out of the Sequence-of-Returns Danger Zone (3-5 years), we plan on selling off these higher-yielding assets and returning back to pure Indexing. And when we do, the readers of Millennial-Revolution.com will be the first to know!

And with that, we’re done. Questions? Comments? Let us have it below.



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44 thoughts on “The Yield Shield: Putting it all Together”

    1. Lots of reasons that I’ve mentioned before, but the primary reason is that the 4% rule is based on an indexed portfolio. Dividend growth investing has not been studied to the extent that indexing has as a way to ensure your portfolio will sustain you for 30+ years.

  1. I am glad that you summed up the entire Yield shield posts. As i was going back n forth to find the below answer as i am in accumulation phase for another 5 years.

    “But remember this: You don’t need to do this during the accumulation phase. You only need to raise the Yield Shield after you retire.”

    Btw..its slightly off the topic and appreciate any one can clarify the below.
    Recently i filed my taxes and my accountant added a capital gain apart from dividend income (small amount though in un registered account) after reviewing the T3A from questrade.
    I am confused as i did not sell/re-balance being in accumulation phase and why am i getting capital gain return..that too i did not see that amount credited in my account either.
    Does the ETF’s rebalance them self internally? Why is it showing in my T3A but did not see that amount credited in account.
    appreciate your feedback.
    NOTE: this is my first time tax filing with these ETF’s (my un registered account has all the 5 ETF’s mentioned in this blog’s canadian portfolio)

    1. Internally some ETFs may buy/sell stuff and they would report this as capital gains for you. This usually isn’t a problem for passive indexed ETFs, but it could still happen when, for example, the index changes and the ETF needs to make some trades to match them. For passive ETFs, the amount should be negligible though.

  2. mak – the small capital gain is most likely capital gains that the ETF experienced (and not a capital gain that was personally directly experienced by you selling something for more than you paid for it) and was returned to you as a distribution.

    Basically, when an ETF pays a distribution, most of it are dividends, but sometimes its designated as a capital gain, other times it’s “Foreign income”, or “Return of Capital”. More related to accounting technicalities of where the money came from.

    To see the details, log into Questrade and click on Reports –> “Tax Slips”. It will probably be a T3 that you’re looking for. Mine were posted on 2nd April.

    1. Thanks TomF,
      Yes, based on T3 received form Questrade, I see the following are the numbers,
      1>[49]Actual Amount of Eligible Dividends – $124.53
      2>[50]Taxable Amount of Eligible Dividends – $171.85
      3>[51]Dividend tax credit for eligible dividends – $25.81
      4>[21]Capital gains – $108.19
      5>[26]Other Income – $9.50
      Out of the which, my accountant added the below amounts to my current income
      $171.85
      $54.10 (I guess he took 50% of the 108.19 capital gain)

      When I asked about how these numbers derived, he advised me to check with Questrade and he followed the box number mentioned in T3 slip.
      I was trying to understand what he filed is correct and T3 slip numbers are similar to rest of the people who hold these ETF’s mentioned in this blogs Canadian portfolio.

      1. I found this very helpful in understanding the taxation of dividends:

        https://www.theglobeandmail.com/globe-investor/investment-ideas/strategy-lab/dividend-investing/you-do-the-math-almost-50000-in-earned-dividends-0-in-tax/article4599950/

        (this relates to lines 1,2 and 3 in your report above)

        As for lines 4 and 5 I believe TomF is right – some of the income distributed was in forms other than dividends, which is very common.

        Here is how you can find it out. You mentioned you followed the investment workshop, so i will walk through an example for one of the 5 funds, VUN.

        First, google “VUN ETF distributions”

        The first result is history of distributions for the VUN ETF. Click it.
        (here is the link: https://vanguardcanada.ca/advisors/mvc/etf-distribution-history.htm?portId=9557)

        What you find is a table showing each distribution. The top is marked “Periodic Distributions” which are usually the quarterly distribution.

        You want to scroll all the way down to the section marked “Annual Distributions”.

        Here you can notice that the total yearly distribution (per share) is broken down into the different forms of income that you get from the fund:

        Eligible dividends
        Non-eligible dividends
        Other income
        Capital gains
        Return of capital.

        Multiply the number of shares you own by the Capital Gains distribution to know how much capital gains income you earned. (you need to do this prorated based on how long you held the stocks if you are still accumulating and buying more shares throughout the year.)

        The “other income” is most likely the “return of capital” portion.

        You can do this for each fund you hold and find the total for your portfolio.

        Of course, if you hold your funds in RRSP/TFSA/RESP non of this matters…
        πŸ™‚

        P.S: I am *not* an accountant nor do I have any formal education is finance/tax etc. This is all self-gathered information and my opinion only.

    1. Of course. Preferreds and dividend stocks give off mostly dividend income, and REITs/bonds give off interest. That’s why Preferreds/dividend stocks are held in non-tax-sheltered accounts while my REITs and bonds are in my RRSPs/TFSAs.

  3. As always, interesting. I am not convinced that the additional volatility you are injecting into these portfolios is worth the yield boost. In my experience, most professional investors go through a phase of obsessing over yield and then realize they are way better off investing from a total return perspective (and keeping a razor focus on asset quality, not yield). But I always like hearing your perspective!

    1. That’s the plan. After a few years I’m planning on lowering my Yield Shield and returning back to a traditionally Indexed portfolio. Just need to make sure I’m not part of the 5% who fail the 4% rule πŸ™‚

      1. Depending on your situation, you may also incur taxes from doing the pivot. You’d then lose a chunk of your capital to tax liability.

        I don’t think early retirees should all be aiming for higher yield. If you’re early retired you probably are going to need growth.

  4. Thanks for the details – Very insightful. Nice to see the examples of how it all comes together.

    Have you given thought to whether the absolute yield would hold up during a market crash?

    For example, I previously calculated the actual cash distributions for various dividend ETFs across multiple years of positive and negative market returns, and found that some continued to increase actual payouts whereas others decreased payouts (even if the % yield increased) as stock prices dropped.

      1. Hi NewB Investor,

        Sure, I can share that. I’ll actually go through my old data, update it, fill in the missing info, and then post it on my page next Thursday. I’ll let you know here when it’s up.

    1. It would take a BIG market correction to completely derail the yield from these sources, and if that happens I would either eat into my cash cushion or use geographic arbitrage to lower my expenses.

      1. Ok so why is now different from a few years from now? You are still retired, not planning on going back to work, don’t you still need a yield shield in case of a market correction?

        I am about 5 years away, should I start a yield shield now? or just simply rebalance to take advantage of the next market cycle? My retirement fund right now is about 60/40.

        Okay, that was 2 questions…

        cheers, great article.

        1. In a few years from now, you will either know whether you are part of the unlucky 5% who retired right as a market crash happens, or you’ll discover you’re part of the other 95% who didn’t need to do bother with this stuff in the first place. Either way, you’ll be out of the danger zone, and you can then decide whether you want to keep your Yield Shield up or whether it’s safe to pivot back to a traditionally Indexed portfolio.

          As for your other question, I’d start building your Yield Shield 3 years out. That’s what we did.

  5. i just re read the article you wrote about returning to indexing

    specifically moving to bonds in retirement .. such as 80 %

    but i am not convinced . i have a cash cushion and a yield shield

    i am retired and FI . age mid 50’s .. in Canada

    so why not continue with more in equities ??

    .. . if i live a long time then why not get more growth …. especially in this rising rate period

    if interest rates were at old high levels then sure buy fixed income .. its safe and high yields

      1. 80’s yes

        but if one retires younger such as 50’s .. one never knows how much you will need when you get to your 80’s .. right now we are paying a fortune for our ailing parents in their final years

        and another point . i have children so why not leave as much as possible . when you have kids you may see the reason to think beyond oneself ..

        as one approaches later years such as 80’s .. its wise then to go to Fixed income …

        but not immediately in ones early years of retirement ??

  6. I guess there’s nothing wrong with (partially) implementing it during the wealth accumulation phase. Like if you have a 80% stocks 20% bonds portfolio, I’d actually choose higher yielding (riskier) bonds during this phase. Especially when interest rates are low…
    But it’s a great summary anyway. Most importantly the theory seemingly works well for you guys πŸ™‚

  7. Instead of selling anything out of your existing portfolio, why don’t you just spend your last 1-2 working years allocating new capital towards your Yield Shield investments? You can even keep these investments long after you retire. Make it a third allocation category: stocks/equites, bonds/fixed income, and pure income/yield. Yes, I’m fully aware that these yield based securities will ultimately be either stocks or bonds.

    I do a similar thing in my 401(k). When the market started going up, I wanted to have more of an equity allocation. Instead of selling any bonds, I just set it so that most new capital goes to stocks. Once the market crashes, I will set it so that ALL new money goes directly to stocks, and then later on a couple years I will change it to more of a mix. All without selling any securities. I can’t touch my 401(k) for another thirty years, so I’m not particularly worried about volatility or keeping my exact 80/20 asset allocation for now.

    Sincerely,
    ARB–Angry Retail Banker

    1. Sure, that’s kind of what I did. I didn’t actually sell anything, just bought more higher yielding stuff near the end.

      As for not touching the 401(k) for 30 years, don’t forget about the 5-year Roth IRA conversion ladder strategy!

  8. High yield bonds are not a good investment right now. Yields are EXTREMELY low, which means that they can only go up. High yield bonds essentially act like the stock market: yields spike and bond prices tank when the stock market goes down.

  9. Maybe this is a dumb question, but you put a lot of work into getting a 3.0% yield for the Canadian portfolio. Oaken is offering 3.1% GIC’s if you lock it up for two years: https://www.oaken.com/gic-rates/.

    Now, I know you hate GIC’s because of the lack of liquidity, and I know GIC’s are taxed unfavourably, but if you can put them in your non-taxable (RRSP) account and you like the peace of mind, wouldn’t that be an option?

    Thanks for the terrific summary.

    1. Problem is, its not long term… so you have to cash them and buy something else. The concept behind indexed etf investing is low cost and low maintenance.

      Also as its ill-liquid, you cant spend it if required, so cannot be considered part of a yield shield.

      cheers

  10. Really nice series of posts about your yield shield. I really like the concept. It makes so much sense. Just raise your shield when you need and lower it when you don’t need it anymore and go back to pure indexing. It’s really nice. I think a retirement portfolio could often use some more yield. Thanks πŸ™‚

  11. Not sure why you think you’re SORR protected. You have not defined your risk, When you moved toward BBB to increase your yield, you increased your risk so if there was a market meltdown, inflation, etc your portfolio is now MORE vulnerable to SORR because it has higher volatility. You did not define what you paid for that increased yield because there is always a cost, and the cost is more risk. You neatly just rationalize it away but when the rubber meets the road it takes more than wishes to do the dishes.

    SORR protection happens by LOWERING your volatility and LOWERING your portfolio withdrawal and LOWERING your exposure to inflation. Not knocking you plan but its conclusions are wishful.

  12. I disagree with this approach as you are increasing the risk of the portfolio in two important ways just as you are starting retirement when you should be decreasing the risk as you are maximally exposed to sequence of return risk at that point. Firstly you are increasing your asset allocation from 60/40 to 85/15, and in fact as corporate bonds have equity like risk (they went down 5% in 2008) it is more like 90/10. Secondly by focusing on income you are creating a less diversified, and therefore riskier portfolio that is more complex and also has higher costs. As you mentioned, the 4% rule uses pure indexing so deviating from indexing, even for only a few years, may compromise chances of success.

    It is simply not true that pure indexers are screwed if they retire in a financial meltdown. You simply live off your government bonds/some cash until the market recovers. Starting retirement at a market peak is all factored into the 4% rule.

    Like dividend stocks, when you take a dividend from a dividend ETF, the price of the ETF, falls by exactly the $ amount of the dividend. It makes absolutely no difference whether you take income as a dividend or sell a sliver of shares and take capital gain. It’s just a framing issue. And, of course, during a crash you wouldn’t do either, instead live off government bonds that go up in price due to the flight to safety.

    A simple way of staying with the total return approach in retirement is described here.

    http://www.moneysense.ca/save/retirement/a-better-way-to-generate-retirement-income/

    1. Pure indexing fails 5% of the time. The Yield Shield is my way of hedging that risk.

      And the Total-Return-vs-Income debate is simply choosing not to have the debate at all. I’m not advocating for pivoting towards yield permanently. Only to escape the sequence-of-return risks of selling into a market storm within the first few years of retirement.

      1. Pure indexing does not fail 5% of the time. Actually the Bengen research indicated a 100% success rate over 30 years for a 75/25 asset allocation and 4% withdrawal rate and a 96% success rate for a 50/50, so a 60/40 would be in between. Of course the FIRE research indicates a 3% withdrawal rate is needed for longer retirements. But I think the point is that by switching to a less diversified portfolio, which will give you a wider dispersion of returns which on average will give you lower returns compared to a more diversified portfolio, even for a short period, you are likely decreasing your probability of lasting the distance. Taking cash as dividends instead of capital gains is not a free lunch.

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