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CD buffer against market downturns
Old 10-18-2008, 11:36 AM   #1
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CD buffer against market downturns

I feel confident in my understanding of the proper accumulation strategies but Im confused about certain distribution strategies. For instance, some people have 5 years or more of living expenses in CDs. I assume that they live off of this money when the market is down like it is now, but how exactly does the logistics of this work? Is it a mechanical thing or is it open to interpretation?

If possible, I'd like someone to break down in detail how they go about living off CD proceeds. Assuming they have a 5 yr CD ladder with each leg being 1 yrs living expenses, what do you do at the end of a bad year (or a good year for that matter)?

Its the end of the year and the market stunk. Do you just cash in the CD that just expired and use that money to live on, leaving yourself with a 4 yr CD ladder....and leave stocks alone?

If so, what happens if the market downturn lasts 2-3 years? Are you left with a 2 yr CD ladder that only gets replenished when the market goes back up and you feel good about selling some stock (funds) to buy CDs?

Is there any preset percentage that the market has to move up or down before any of this takes place?

Would anyone like to describe their distribution method in bad AND good times? Ive never spent much time thinking about distribution since so im interested for myself but also for my mother who just retired and has no idea what shes doing.
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Old 10-18-2008, 12:09 PM   #2
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It is called CD laddering. You set it up so you will have a year's worth of expenses maturing each year. So, you get a 1-year, 2-year, 3-year, 4-year, and 5-year CD with five year's worth of living expenses. You simply re-invest any money you do need each year in a 5-year CD after that (this would happen if you had leftover money from last year) plus you pull money from your other accounts to properly fund the CD to a year's worth of expenses (however you should not pull from the volatile funds in a recession, so you essentially will slowly running through your CD ladder through this time, a downturn has never lasted 5-years straight, even the Depression had up points where you could have withdrawn money easily, even though overall it extended 10 years).

It will not matter if the market is doing "poorly" or "well", the money you need for each of those years should arrive regardless. You are essentially paying for this though, because your money will not be earning the returns volatile assets bring. However, this is not to say you shouldn't do it, volatility has its own price as well, essentially the volatile asset cannot be drawn from at certain times (when it is at a low point). This is the whole point behind people holding a certain year's worth of expenses in a fixed cash-income source.

FDIC limits had to be taken into consideration, but since it has been raised to 250k, you will likely only need to divide where you get the CD's up between two institutions at for now (or more if you want).

Usually, people use more than just CD's and stocks. These are the two extremes of the risk spectrum (ignoring leverage). CDs simply should not be used as your only source of income other than stocks. People will usually hold TIPS (tax and inflation protected securities), bonds (many types of this actually, depends on your situation which you use, junk bonds or corporate bonds for instance can be as risky as stocks), or treasury bills, depending on their tax situation. These conservative investments are what are drawn on if stocks are performing poorly, usually during distribution, these will make up a huge portion of your portfolio, well over 5-years expenses, usually at least 10-years.

Then there is diversification, even within the risky assets, there are types which have low correlations to stocks (they stay up when stocks go down). By doing this you can often have a lower amount of low-risk assets, increasing your overall return.

Going to stop there, to put it simply, once you stop looking at just CDs, there is a lot to learn, and I cannot cover it in a single post, but it is well worth learning it, your entire income is affected by your knowledge about these sorts of things.
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Old 10-18-2008, 12:32 PM   #3
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Example: 5 year ladder of 5 $100K CD's (not all in same institution so FDIC is considered).Total in the pot $500K. Take interest monthly, maybe $2.5K a month, depending on interest rate and not touching the principal. As each CD matures (rung 1) you purchase a new 5 Year $100K CD (this becomes the new rung 5).

Works the same if you want to go beyond 5 years. Personally, I have one that currently goes out 6 years and has been as long as 10 years in the recent past.
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Old 10-18-2008, 12:57 PM   #4
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OAG, that helps, but Im still confused.

Lets say a person needs / wants $40K per year.
He has a total of $1,000,000 so he can withdraw 4% and get his $40K

Hes not going to be able to draw enough interest from the CDs to live on unless he puts almost his entire nest egg in CDs. Thats why I assumed he had to use the principal to live on (and not just the interest). But if he used the principal, his ladder would be getting shorter, rung by rung, as each year of a down market goes by.
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Old 10-18-2008, 01:11 PM   #5
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Originally Posted by utrecht View Post
OAG, that helps, but Im still confused.

Lets say a person needs / wants $40K per year.
He has a total of $1,000,000 so he can withdraw 4% and get his $40K

Hes not going to be able to draw enough interest from the CDs to live on unless he puts almost his entire nest egg in CDs. Thats why I assumed he had to use the principal to live on (and not just the interest). But if he used the principal, his ladder would be getting shorter, rung by rung, as each year of a down market goes by.
Well you need your stocks to produce some dividend income also. If you have $500k in cd's paying 5% that gives you $25k. The other 500k in stocks would need to yield 3% which is very doable today. That gives you $15k which in total gives you your 4% w/d you are seeking. Also some would say pssst Wellesley. A balanced fund you could put the whole thing in yielding almost 5%.
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Old 10-18-2008, 01:22 PM   #6
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I recommend you read Lucia's Buckets of Money. While that strategy is not perfect, it provides a very elegant and well-tested withdrawal strategy. In a nutshell, you might have 3-4 years in cash or near cash (Bucket 1), similar amount in bonds (bucket 2) and the rest in stocks (bucket 3).

You simply take your 4% (or whatever you choose) from bucket 1 til it's gone. Then refill Bucket 1 from the now-expanded amount in Bucket 2 and repeat. When you get to almost all stocks, you re-allocate and start again.

During all this, if stocks are doing particularly well (as they likely will over 10-15 years) you can gently rebalance by putting half the "above planned for" stock gains in Bucket 2. This is greatly over-simplified but hopefully you can get the idea.
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Old 10-18-2008, 01:45 PM   #7
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So you start with
12% Cash (3 years times 4%)
12% Bonds
76% Stocks

Assuming $1 Mil, it would be

$120,000 Cash
$120,000 Bonds
$760,000 Stocks

After 1 year you might be left with:

$86000 Cash (spent $40K and got $6K interest)
$128000 Bonds (7% gain)
$836,000 Stocks (10% Gain)

After 2 years...

$50000 Cash
$137000 Bonds
$920000 Stocks

After 3 years cash is close to gone and bonds are worth maybe $150,000 so you sell $120,000 in bonds to reset back to 3 years of cash?

The entire process makes sense to me now although the amounts dont seem right. After 3 years you went from

12% Cash
12% Bonds
76% Stocks

To
12% Cash
3% Bonds
85% Stocks

Are you saying this is correct during down markets , but during up markets you would do the "gentle rebalance" and sell stock to replenish the bonds? Hmm..sounds like a book I might need to buy. Thanks!
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Old 10-18-2008, 01:48 PM   #8
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Any other book you would like to recommend? I need to spend another $10 to get free shipping
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Old 10-18-2008, 04:46 PM   #9
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Here is a similar approach using a 5 year CD ladder and $1 million.

During normal times you have a $40K (ignore inflation for simplicity) a year spread out of over 5 years worth of CD. A 100K in money markets and bond funds, the remaining 700K in equities. The CD averages 6% and the money market/bond funds 5%. This provides 17K of income a year. The remaining 23K on income + inflation adjustments comes from equities.

Each year when you rebalance, you buy another 5 Year CD, unless the market is down. 2008 comes along the market tanks, now when you rebalance you find the following.

Cash flow
Interest income 15K (down from 17K due to a drop in MM interest rates)
Expense 40K
Net Cash -25K

Balance Sheet
MM/Bond Fund 100K (normally we'd see bonds increase due to lower interest rates but this year only government bond funds increased)
CDs 200K
Equities 525K (25% drop)
Net Cash -25K
==============
Total 800K

When you rebalance to a 70/30 AA, instead of buying another 5 year CD you put the money in the market.
CD 160K @6%
MM/Bond fund 80K @3%
Equities 560K

Next year equities continue to drop modestly (cushioned by higher dividend yield) and your interest income drops to 12K.

CD 160K
MM/Bond 80K
Equities 538K
Net cash -28K
============
Total 750K

Once again money from the CD is used primarily for expenses. Perhaps roll over only 10K into a 5 year CD. Leaving you with an AA that looks like this
CD 130K
MM/Bond 80K
Equities 540K.

The next year when the Bull market returns and the S&P is up 37% (1975) or 50% (1933) when you rebalance you start to back fill the CD.

To be honest I never was a fan of CD ladders, but after this market, I am beginning to see the wisdom of having them. At the beginning of the year I had roughly $150K in cash, but because it was in a money market I found it way to easy to keep buying as stocks kept getting cheaper. A couple of weeks ago I found myself out of cash. I think if I had a CD ladder of a few years expenses I'd feel better.
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Old 10-18-2008, 10:34 PM   #10
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Here is a similar approach using a 5 year CD ladder and $1 million.

During normal times you have a $40K (ignore inflation for simplicity) a year spread out of over 5 years worth of CD. A 100K in money markets and bond funds, the remaining 700K in equities. The CD averages 6% and the money market/bond funds 5%. This provides 17K of income a year. The remaining 23K on income + inflation adjustments comes from equities.

Each year when you rebalance, you buy another 5 Year CD, unless the market is down. 2008 comes along the market tanks, now when you rebalance you find the following.

Cash flow
Interest income 15K (down from 17K due to a drop in MM interest rates)
Expense 40K
Net Cash -25K

Balance Sheet
MM/Bond Fund 100K (normally we'd see bonds increase due to lower interest rates but this year only government bond funds increased)
CDs 200K
Equities 525K (25% drop)
Net Cash -25K
==============
Total 800K

When you rebalance to a 70/30 AA, instead of buying another 5 year CD you put the money in the market.
CD 160K @6%
MM/Bond fund 80K @3%
Equities 560K

Next year equities continue to drop modestly (cushioned by higher dividend yield) and your interest income drops to 12K.

CD 160K
MM/Bond 80K
Equities 538K
Net cash -28K
============
Total 750K

Once again money from the CD is used primarily for expenses. Perhaps roll over only 10K into a 5 year CD. Leaving you with an AA that looks like this
CD 130K
MM/Bond 80K
Equities 540K.

The next year when the Bull market returns and the S&P is up 37% (1975) or 50% (1933) when you rebalance you start to back fill the CD.

To be honest I never was a fan of CD ladders, but after this market, I am beginning to see the wisdom of having them. At the beginning of the year I had roughly $150K in cash, but because it was in a money market I found it way to easy to keep buying as stocks kept getting cheaper. A couple of weeks ago I found myself out of cash. I think if I had a CD ladder of a few years expenses I'd feel better.
That's a very interesting approach that I will study further. For my retirement income, I was planning on relying primarily on dividends. So using the example above, I would have:

200K in CDs at 6% interest
300K in MM and bonds at 5% dividend
500K in equities (value tilt with a healthy dose of REITs) at 3% dividend.

total interest + dividend income in the first year would be $42K. Use 40K to pay bills, reinvest the 2K left.

If during the second year interest rates and the stock market go down, I figure the drop in interest income might be partly compensated by an increase in equity dividends. So let's say interest + dividend income = 36K for year 2, then I would take 4K out of the maturing CD and reinvest the rest. At the end of the year I would rebalance and buy equities using the MM/bonds portion.

If the market recovers the year after that, then I would once again rebalance by selling equities and replenishing the CDs and MM/bonds.

Is there anything inherently wrong with that approach?
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Old 10-19-2008, 03:30 PM   #11
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That's a very interesting approach that I will study further. For my retirement income, I was planning on relying primarily on dividends. So using the example above, I would have:

200K in CDs at 6% interest
300K in MM and bonds at 5% dividend
500K in equities (value tilt with a healthy dose of REITs) at 3% dividend.

total interest + dividend income in the first year would be $42K. Use 40K to pay bills, reinvest the 2K left.
I think it is fine. In fact dividend income is mine (and a couple of others on the boards) primary focus. The difference between my AA and your poposal was I was 70 (now almost 80%) equities and 20-30% MM/Bonds. I have few CDs cause with rare exceptions I always found a "superior" investment to CD. What I (and believe Ha Ha) discovered during this bear market is that while dividend income is reasonably reliable, dividend cuts happen. The cash in MM fund, at least in my case, is way too easy to commit to a declining market as a value investor. A multi year CD ladder has some advantages that frankly I didn't give enough weight to, safety, ease of implementation, interest rates higher than treasury, and most importantly fixed periodic cash flow,

Like most everything in retirement finances there are multiple reasonable approaches. The goal in all of these cases is to be smarter than investment bankers, and hedge fund manager and not be forced to liquidate equities near the bottom of a bear market cause you need to raise cash.
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Old 10-19-2008, 04:02 PM   #12
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I think it is fine. In fact dividend income is mine (and a couple of others on the boards) primary focus. The difference between my AA and your poposal was I was 70 (now almost 80%) equities and 20-30% MM/Bonds. I have few CDs cause with rare exceptions I always found a "superior" investment to CD. What I (and believe Ha Ha) discovered during this bear market is that while dividend income is reasonably reliable, dividend cuts happen. The cash in MM fund, at least in my case, is way too easy to commit to a declining market as a value investor. A multi year CD ladder has some advantages that frankly I didn't give enough weight to, safety, ease of implementation, interest rates higher than treasury, and most importantly fixed periodic cash flow,

Like most everything in retirement finances there are multiple reasonable approaches. The goal in all of these cases is to be smarter than investment bankers, and hedge fund manager and not be forced to liquidate equities near the bottom of a bear market cause you need to raise cash.
Thanks Clifp.

I understand what you mean when you say "The cash in MM fund, at least in my case, is way too easy to commit to a declining market as a value investor". I have slipped several times myself in the past week, using part of our EF (VG prime money market) to buy equities, I know... it's bad. So locking in some money in CDs will probably be a good thing for me too.
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Old 10-21-2008, 03:22 AM   #13
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i 2nd the ray lucia buckets method, thankfully 2 years ago i caught his seminar and structured the buckets like we were retiring tomorrow even though we still have a few years to go,.

with 15 years worth of withdrawls already in buckets 1 and 2 we have been able to watch this debacle more as a spectator and although our stock bucket is down about 35% we have the comfort of knowing we can have up to 15 years before we liquidate our first stock fund
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