1/13/2014 7:15 PM ET|
Why your nest egg needs a cash cache
Portfolios that include a one-year cash reserve are better able to withstand the impact of taxes, transaction costs and volatility, a new study shows.
With savings accounts and certificates of deposit continuing to pay next to nothing, you may fret that you'll throttle your nest egg if you follow the widespread advice to maintain a cash reserve of up to a year for expenses.
No worries: A new study shows that your nest egg may actually last longer if you keep a one-year cache of cash.
Researchers found that both taxable and tax-deferred accounts with cash reserves generally have better survival rates over a 30-year retirement than accounts without a cash allocation. Portfolios that include cash are better able to withstand the impact of taxes, transaction costs and volatility, the researchers found.
Many financial advisers have long recommended cash reserves as insurance against investors having to sell investments in down markets to cover expenses. Others, however, counter that large cash reserves earning close to 1 percent or less crimp a portfolio's performance.
The latest study shows that when the costs of taxes and trading are taken into account, having a cash stockpile can more than offset the higher returns produced by investing the cash in other assets.
The researchers compared two $200,000 retirement nest eggs. One had an allocation of 60 percent stocks and 40 percent bonds. The other nest egg had two buckets. Four percent of the portfolio was allocated to cash, enough, at an inflation-adjusted 4 percent withdrawal rate, to pay for expenses for a year. (Presumably, the retiree had to supplement the $8,000 expenses reserve with Social Security, pension payouts, rental income or a part-time job.) The other bucket was allocated to stocks and bonds at slightly lower percentages than the first nest egg. In one scenario, the retirees' assets were in taxable accounts, while in another they were in tax-deferred accounts, such as an IRA or a 401k.
Assuming an inflation-adjusted 4 percent withdrawal rate, the tax-deferred account without a cash reserve had a 55 percent chance of surviving 30 years, compared with 59.4 percent for the tax-deferred account with the cash reserve. The non-cash nest egg incurred a median $21,600 in transaction costs over 30 years, compared with a significantly smaller $2,520 for the nest egg with the cash reserve.
Cash was king as well when both nest eggs were in taxable brokerage accounts. The survival rate for the account with the cash reserve was 66 percent, compared with 60 percent for the account without the cash bucket. The transaction costs were similar to those in the tax-deferred accounts.
The accounts without the cash reserve had considerable trading costs because the investment portfolios needed to be tapped every month for expenses, says study co-author John Salter, associate professor of personal financial planning at Texas Tech University. Each trade was assumed to cost $30, far more than fees charged by discount brokers but less than typically charged by full-service brokers. The study assumed two trades each month.
Slashing transaction costs
Meanwhile, stocks and bonds in the accounts with the cash cache were tapped once a year when the reserve needed to be replenished. "Instead of transaction costs 12 times a year, we're incurring those costs only once," says Salter, who also is a certified financial planner at Evensky & Katz Wealth Management, in Lubbock, Texas. Co-authors were Harold Evensky, president of the firm, and Shaun Pfeiffer, associate professor of finance at Edinboro University, in Edinboro, Pa.
For the taxable accounts, the median tax bite over 30 years was slightly higher for the nest egg without the cash reserve -- $73,993 compared with $71,886. All the trades were assumed to incur 15 percent long-term capital gains.
One reason for the higher tax tab: More income comes from the stocks and bonds than from the cash. In an actual portfolio, accounts without the cash reserves would likely rack up more taxes because some of the monthly trades would throw off short-term capital gains, which are taxed at ordinary income tax rates of up to 43.4 percent, Salter says.
Salter says that for many years, his firm set up two-year cash reserves for clients. The more cash, the lower the transaction costs -- but "there is also an opportunity cost of more cash not being invested," he says. In today's markets, he says, "one year ended up being the optimal solution to the tug of war."
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I agree with the basic investment philosophy of the article. Cash is king. But, the numbers in this article don’t make sense for most people. How many are living on $8k per year and have a 200k portfolio? And frankly, even a 59% chance of survival doesn't exactly ring my bell. Do your own math. Everyone’s situation is unique. To protect yourself financially, your first goal should be to eliminate all debt. 99% of all financial disasters are caused by debt. That’s equally true for corporations and investor gurus as it is for small investors. If you don’t like the idea of paying off your mortgage instead of investing in the stock market, maybe your home isn’t such a great investment after all and it’s time to downsize to the size of your equity. Once you get past the psychological hurdle of needing to live with debt, you should strive to accumulate and or guarantee at least two years of total annual expenses in cash and cash equivalent income before even thinking about investing in anything else. (Note: by investing, I mean committing your money to something for more than 90 days; the ridiculous Wall Street definition of long term). I know this probably means taking a loss on your cash savings in real terms against inflation. But, you can thank the Fed and their zero interest rate policy for that, and the alternative is even worse. Just ask anyone who lost their home or life savings to the Fed money printing bubble machine and the stock market in 2001, 2008…. pick any moment in history you like.
Funny thing can happen when you keep a cash cache. It can get out of hand, and grow, and come to beggar a year's value; then a decade's; then you turn around and find you can well walk off that last job at maybe 58 or 61; and darnedest thing - living well really is the best revenge!
Although, I believe it is important to have a diversified investment portfolio I think it make sense to have a readily available stash of cash. One of the lessons my parents taught me is to always have a rainy day fund for emergencies. I have always been a good savor. I always put aside some easily accessed cash for the unexpected event.
I have been working since I have been a teenager and through out the years that extra nest egg of cash served me well. I have lost jobs through downsizing and had to start over. Instead of selling off investments I had available cash to help me through lives rough patches. When an unforeseen expense came up I had the money available for the expenditure.
I have loaned family and friends money and helped them out because of my cash fund. I am in my fifties and have a diversified portfolio and a nice sized retirement fund. Even though I wished interest rates were higher I still keep a sizable amount of readily available cash in a rainy day fund.
I may not be making a lot of interest on the cash I keep in that fund but I have peace of mind knowing I have a readily available emergency fund for the unexpected occasion.
I have 2 rainy day piles, the first is a years worth of expenses including mortgage, taxes, utilities, living expenses. About half is invested in a fed & CA state tax free bonds fund, current return is about 2.5% and growth has been positive, the balance is a mix of savings accounts and CD's, return is about 2%. The second is approaching 14 months of expenses invested in mutual's, those funds are growing at a very good rate (18% last year).
I'm currently contributing the max allowed to my 401K and adding about 10% of my wages to the second pile of savings. With only 15 months until my normal retirement date I'm ready, however I might just hang around for another year as my company is sweetening the pot trying to get me to stay on. Either way I will not be seeing a change in lifestyle and will have to pay taxes on 85% of my Social Security benefits.
Point is start saving early and continue even in retirement.
Forget about trying to create a pile of money big enough to allow you to retire. Instead, spend your time creating or acquiring assets that will generate enough consistent cash flow to support you when you retire.
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