Inflation Proofing Your Portfolio

I ran a sensitivity test on my Simplified Automatic Allocator.

I looked at dividend blend portfolios at various inflation rates. You can withdraw 5% of your original balance (plus inflation) today even if inflation climbs to 6%. If inflation stays at 3%, you can withdraw 6.5% (plus inflation).

The Dividend Blend Concept

The dividend blend is a cash management concept. You never sell any shares.

The dividend blend consists of a high yielding portfolio with little dividend growth combined with a portfolio with a lower initial yield that grows its dividend amount rapidly. Excess cash generated by the high yielding portfolio covers shortfalls during the middle years. The fast growing portfolio eventually takes over, providing a continuing income stream.

I assume that the high yielding portfolio does not grow fast enough to match inflation.

Dividend Blend Portfolio

I used DVY for my high growth portfolio. It currently has a dividend yield of 4.5% and a dividend growth rate in excess of 7.5%.

I used BAC (Bank of America) preferred shares (callable in 5 years, non cumulative) for my high yield portfolio. It has an 8.2% dividend yield (constant).

I assumed a TIPS interest rate of 2% (real) for cash management. This was necessary for purposes of analysis. In actuality, you would put excess cash back into your investment portfolios. I started with an initial TIPS balance of zero.

Simplified Automatic Allocator Results

The best allocation shifted with inflation rates. As a rule, higher inflation rates required a higher initial allocation into the high growth portfolio. Lower inflation rates require higher initial allocations into the high yield portfolio.

6% inflation

70% High Growth, 30% High Yield: a withdrawal rate of 5.0% grew continually faster than inflation.

60% High Growth, 40% High Yield: a withdrawal rate of 5.0% survived for 29 years. At Year 30, the withdrawal amount was 4.7% of the original balance (plus inflation).

5% inflation

60% High Growth, 40% High Yield: a withdrawal rate of 5.5% grew continually faster than inflation.

50% High Growth, 50% High Yield: a withdrawal rate of 5.5% survived for 25 years. At Year 26, the withdrawal amount was 5.3% of the original balance (plus inflation). The withdrawal rate recovered to 5.5% at Year 30 and beyond.

4% inflation

50% High Growth, 50% High Yield: a withdrawal rate of 6.3% grew continually faster than inflation.

40% High Growth, 60% High Yield: a withdrawal rate of 6.3% grew continually faster than inflation.

3% inflation

40% High Growth, 60% High Yield: a withdrawal rate of 6.5% grew continually faster than inflation.

50% High Growth, 50% High Yield: a withdrawal rate of 6.5% failed. It was higher than the initial yield of the combined portfolios.

Conclusions

With a dividend blend, using today’s investments, you can withdraw more than 6% (plus inflation) continually using a dividend blend so long as the inflation rate is 4% or less. You can withdraw 5.5% (plus inflation) at a 5% inflation rate. You would be able to withdraw 5% (plus inflation) even if the inflation rate were as high as 6%.

As the inflation rate increases, you should allocate more to the faster growing portfolio.

As always, I recommend limiting withdrawals to 5.0% to 5.5% for the first few years until you are comfortable with your investments.

Have fun.

John Walter Russell
July 2, 2008