This is Part 2 of 3 on the general subject of merging withdrawal methods for retirement portfolios. Part 1, to be read first, contains the general description. Part 3 hosts withdrawal simulations based on the portfolio described in part 2. Part 3 contains tables summarizing results.
One Application
To illustrate how this portfolio segment/distribution scheme might work, let me use my personal portfolio (without getting too revealing). My portfolio is divided into 5 segments: 1) Dividend Growth  low yield/high dividend growth stocks; 2) High Income  high(er) yield/moderate dividend growth stocks; 3) Core  ETFs featuring (but not limited to) international equities; 4) Bond  ETF/CEF bond funds; 5) Mélange  a less pristine mixture that could consist of all of the above, plus no dividendhigh beta stocks. Each of these segments will be discussed in more detail later.
These portfolio segments are evenly split initially between low/high income. Selection of individual assets is governed in large part by how much income is available at different times in the time period: high income bears the brunt in the first half with income from dividend growth doing likewise in the latter part. To repeat, the portfolio is heavily dividend growth oriented.
The portfolio also takes into account real life in today's low interest rates for fixed income assets. This means some MLP, REIT, BDC/mREIT, junk bond inclusions. To those who would say these are risky, what is the alternative given current bond yields? Boosting withdrawal rates means earlier retirement on a smaller grub stake. Besides, my plan sells them earlier in the distribution phase. Again, unwind the portfolio before it falls apart. The question may not be if (they are included), but how much to allocate. Risk needs to be balanced with reward. There is only one item in the investment world that is considered risk free. That is the 90day Treasury bill, which (on a relative basis) is risk free only 'by definition'. On an absolute scale, even that has risk; the printing presses could run out of ink. All this to say, nothing is truly risk free, just choose it wisely.
To determine the dividend growth (dg) to be used in distribution calculations, I will be using a four year 2007 vs 2008 to 2010 vs 2011 average for each segment as a guide, a very conservative approach. The next step is to determine initial portfolio allocation between these segments with some general thought on relative distribution flows so that it all hangs together.
Starting with Dividend Growth segment, a 30% allocation with a 3% yield and 10% dividend growth would result in an initial payout of $3600 ($400K * 0.3 * 0.03). Using the Rule of 72, this would double every 7.2 years (assuming no stock sales) or 5 times within the 40 year period. The $3600 grows to $115,200, more than enough  meaning it doesn't have to do this well, but close. So the challenge now is to assemble this segment with stocks with these yield/dividend growth characteristics realizing that growth has to be maintained or an alternative to lost income provided (such as selling shares or replacing poor performers with better choices).
This defines the metrics needed to select candidates for the segment and a rough idea of yearly values of Z, say Z=0 for the first 20 years, then increasing linearly to some end value depending on dividend growth, namely, Final Z = 2.4  20*dg, yielding values of zero for dg greater than/equal to 0.12 and one (1) for values less than/equal to 0.07.
My portfolio has 36 stocks in this segment, represented in the following categories: Consumer goods  Procter & Gamble (NYSE:PG) Unilever (NYSE:UL); Business services  Automatic Data Processing (NYSE:APD) Healthcare Services Group (NASDAQ:HCSG); Industrial  Illinois Tool Works (NYSE:ITW) Union Pacific (NYSE:UNP); Medical  Owens & Minor (NYSE:OMI) Medtronics (NYSE:MDT); Retail products  General Mills (NYSE:GIS) Hasbro (NASDAQ:HAS); Food services  McDonald's (NYSE:MCD) Darden Restaurants (NYSE:DRI); Consumer services  Target (NYSE:TGT) Time Warner (NYSE:TWX); Drugs  Abbott Labs (NYSE:ABT) AstraZeneca (NYSE:AZN); Tech  Intel (NASDAQ:INTC) Xilinx (NASDAQ:XLNX).
Average yield for the Dividend Growth segment is 3.2%, 4yr dg from 2007/82010/11 is 20.3%, 11.2%, 10.3%, 10.9% for an average of 13.2%. I will use 11% since no stocks are sold (on a net basis) for the first 20 years and dividend growth has to hold. From the formula above, Final Z is 0.2. In the distribution simulation (Part 3 of this series), exponential dg is gradually decreased to half its initial value at the end of the time period.
The High Income segment contains stocks from the following sectors: Utilities, MLPs, REITs, Telecoms and other higher yield moderate dividend growth equities. It also has a 30% allocation, balancing a low/high income split criteria. The desire to offload some of the more risky elements means a fairly high Start Z (two times Initial Z) with, say, a midpoint value of one (1), falling off to a value depending on, again, dividend growth. Here the formula used is 1.667  16.667*dg; zero for dg greater than/equal to 0.1 and one (1) for values less than/equal to 0.04.
My portfolio has 29 stocks in the High Income segment, represented by the following categories: Utilities  NextEra Energy (NYSE:NEE) Avista (NYSE:AVA); REITs  Digital Realty (NYSE:DLR) Omega Healthcare Investors (NYSE:OHI); Pipelines  Western Gas Partners (NYSE:WES) Sunoco Logistics Partners (NYSE:SXL); Services  Shaw Communications (NYSE:SJR) CenturyLink (NYSE:CTL); Natural resources  Penn Virginia Resource Partners (NYSE:PVR) Rayonier (NYSE:RYN); Gas/oil  EV Energy Partners (NASDAQ:EVEP) Pioneer Southwest Energy Partners (PSE); Products  CRH (NYSE:CRH); Transport  TransMontaigne Partners (NYSE:TLP) Textainer Group (NYSE:TGH).
Average yield for the High Income segment is 5.6%, 4yr dg from 2007/82010/11 is 14.0%, 7.5%, 5.4%, 6.3% for an average of 8.3%. I will use 7% in the distribution simulation, where dividend growth is assumed to be linear. By selling poor stocks early, segment dividend growth should hold. Final Z is 0.50.
The Core segment consists entirely of ETFs, mostly international. It has a 15% allocation and is part of the low yield, high dividend growth consideration. Start Z value is equal to the Initial Z calculated, no multiplier. The Final Z formula is 1.667  16.667*dg, zero for dg greater than/equal to 0.1 and one (1) for dg less than/equal to 0.4.
My portfolio has 15 equities in the Core segment, represented by: Domestic  Vanguard Industrials (NYSEARCA:VIS) Vanguard Consumer Staples (NYSEARCA:VDC); Emerging markets  WisdomTree Emerging Markets Equity (NYSEARCA:DEM) iShares S&P Latin America 40 (NYSEARCA:ILF); Developed markets  WisdomTree Int Small Cap Div (NYSEARCA:DLS) WisdomTree DEFA (NYSEARCA:DWM); Pacific x Japan  iShares MSCI Pacific exJapan (NYSEARCA:EPP); International x US  WisdomTree Commodity Country Equity (NYSEARCA:CCXE) WisdomTree Emerging Mkts Small Cap Div (NYSEARCA:DGS); Global  iShares S&P Infrastructure Index (NYSEARCA:IGF) Vanguard FTSE AllWorld exUS (NYSEARCA:VEU). Average yield, 3.9%, 4yr dg is 6.4%, 0.7%, 13.8%, 21.3% for an average of 10.2%. I will use 9% dg in the distribution simulation, where dividend growth is an average between exponential and linear. Final Z is 0.167.
Note that compared with Dividend Growth and High Income segments, dividends were cut, the minimum came a year earlier and recovery was faster. This may have happened because some of the ETFs had bank stocks in their portfolio at the start of the financial crisis which were later purged. I am a little leery of mutual funds in general because dividend growth is not in their bag. I don't do equity mutual funds, open or closed. I can find no equity ETF that has consistent dividend growth at a reasonable yield. This is not a formidable task as David Fish's ChampionsChallengersContenders lists have shown. Message to ETF creators: "C'Mon Man!"
The Mélange segment has a proper title. Here dividend growth is welcome but not required. It can be the residence for initial positions as well as those marginally held (as in 'shapeup or shipout') with anything in between. Initial Z multiplier is three times Initial Z calculated. This recognizes risks involved and the need to boost early payout. This segment has a 15% allocation and is generally 1/3 low dividend  2/3 high, rounding out the portfolio split of 50/50. Here we use a different payout cycle. The time period is reduced from 40 to 30 years; the 3*Init Z value is held for the first 10 years, increased/decreased for the next 5 years to Z=1, which is held for the remaining years.
My Melange segment has 18 positions, all equities at this time, represented by: Low yield ETFs  Vanguard Small Cap (NYSEARCA:VB) SPDR S&P International Div (NYSEARCA:DWX) Market Vectors Steel (NYSEARCA:SLX); Shipping  Navios Maritime Partners (NYSE:NMM); Tech  Perion Network (NASDAQ:PERI) Microchip Technology (NASDAQ:MCHP); mREIT  Annaly Capital Management (NYSE:NLY); Business Services  SeaDrill (NYSE:SDRL) Triangle Capital (NYSE:TCAP); Natural Resources  Dorchester Minerals (NASDAQ:DMLP) Natural Resource Partners (NYSE:NRP); REITs  Realty Income (NYSE:O); Consumer Services  Verizon (NYSE:VZ) BCE (NYSE:BCE). Average yield is 6%. While the 4yr dg is not a metric, it runs near zero with some yearly variation. Some positions held here are cyclical and will be replaced (hopefully) at the proper time.
The Bond segment holds 9 positions, represented by: Treasuries  AllianceBernstein Income (NYSE:ACG); Emerging Markets  Templeton Global Income (NYSE:GIM); Municipals  Invesco Value Municipal (NYSE:IIM) plus 2 discrete munis; Junk  SPDR Barclays Capital High Yield (NYSEARCA:JNK), Oil/Gas  Pengrowth Energy (NYSE:PGH). The latter is there to beef up the allocation, which is 10%, as well as help lower price variations when interest rates go up. PGH is an x CANROY with a high yield and some negative correlation with bonds. There are 3 CEFs listed, the only ones I own.
Average yield in the Bond segment is 7.5%. Start Z is 1+Init Z/2, Final Z is one (1). Number of years for distribution is determined by the formula 21.7 + 33 * Pb/P, where Pb/P is the ratio of bond segment to total portfolio. This distribution has a linearly decreasing amount if the segment share value is constant, otherwise goes up and down a small amount around a linear path.
This is a good distribution for bonds; high initial amount, decreasing in time and terminating early (before inflation takes its toll). Since interest payments are fixed (more or less) and the price is reasonably constant (or may go against you), it is better to take it early. Besides, this distribution fits nicely with increasing payouts from the Dividend Growth segment.
Bucketeers should love this segment. The front end could be loaded with cash/short term bonds, higher yields saved for later. Since share price is constant (assumed), everything that is needed is known. We know how much payout (principal and interest) is required at all points of time. Discrete bonds, laddered or not, could be added in later with maturities preselected. These would add credibility to a constant share price assumption. The balance of required payout could be filled with bond funds, taking interest payments and selling principal as needed.
Now, pulling together salient metrics for each segment, we have:
Metric 
Dividend Growth 
Hi Income 
Core 
Mélange 
Bond 
Initial Value 
$120K 
$120K 
$60K 
$60K 
$40K 
Initial yield 
0.032 
0.056 
0.039 
0.060 
0.075 
Dividend growth 
0.11 
0.07 
0.09 
0 
0 
Where K = thousand $ Total Initial Value = $400K
Weighted dg = [120(0.11)+120(0.07)+60(0.09)]/(120+120+60) = 0.09
Initial D&I = $120K(0.032)+120K(0.056)+60K(0.039)+60K(0.06)+40K(0.075) = $19.5K
G = $19.5K[(1+0.09)/(1+0.036)]^3 = $22.711K
Init Z = (22.711K19.5K)*40/(120K+60K+60K+40K) = 0.459
Metric 
Dividend Gr 
Hi Income 
Core 
Mélange 
Bond 
Start Z 
0.459(0) 
0.459(2) 
0.459(1) 
0.459(3) 
1+0.459/2 
= 0 
= 0.918 
= 0.459 
= 1.377 
= 1.23 

Initial T 
36.4 
36.4 
36.4 
30 
25 
Initial Principal 
0 
$3026 
$757 
$2754 
$1968 
Initial D&I 
$3840 
$6720 
$2340 
$3600 
$3000 
Initial Payout 
$3840 
$9746 
$3097 
$6354 
$4968 
Midterm Z 
0 
1 

Final Z 
0.2 
0.375 
0.1 
1 
1 
Total Initial Payout = $28005
This payout represents an initial 7% rate. Actually, that is a little high, the correct number is $27500. The calculation above treats shares sold and D&I separately. In my distribution simulation, I assume that the year's shares sold would occur early in the year so that these funds would be available during that calendar year. Shares sold cannot pay D&I. Since the amount of principal sold is small the first year, where this calculation takes place, it is easier to do the calculation as indicated, realizing results are a little high. It makes it easier when you are playing 'what if' in trying different combinations of segment allocation, yields, dividend growth, etc.
Note in the table above Start, Midterm and Final Z values for each segment. Mélange and Bond have high values, indicating a desire to sell risky assets early (and provide high early year payout). High Income is next with slightly lower Z values. Dividend Growth and Core have low Z values, keeping those shares for the second half of the time period. Assets in these segments are lower relative risk.
Part 3 of this series will illustrate how a portfolio with these characteristics fares in distribution scenarios.
Disclosure: I am long all stocks and bond funds listed.