Cash Calculation

[RetireAge50]

I'm thinking I would like to protect against market falls by having about 2 years worth of cash. As an example assume a 1 million portfolio, $20,000 pension, yearly spending of $50,000, and maybe a worse case decline of 30%.

How much cash should I hold?

A. $60,000 (2 years * $30,000)
B. $18,000 (2 years * $30,000 * 30%)

 

[pb4uski]

I would think A.... if equities cratered then between your $60k in cash and pension you can pay for your $50k living expenses for two years.

However, you might also consider reducing the $60k for two years worth of taxable account dividends... so between cash, taxable account dividends and pension you can pay for your $50k living expenses for 2 years.

 

[FlaGator]

I would think A.... if equities cratered then between your $60k in cash and pension you can pay for your $50k living expenses for two years.

However, you might also consider reducing the $60k for two years worth of taxable account dividends... so between cash, taxable account dividends and pension you can pay for your $50k living expenses for 2 years.

+1
The value of being liquid when the paycheck stops can not be overestimated. Also suggest looking at your asset allocation as well to ensure you can ride out any declines without selling equities in a down market to support yourself.

 

[RetireAge50]

I would think A.... if equities cratered then between your $60k in cash and pension you can pay for your $50k living expenses for two years.

However, you might also consider reducing the $60k for two years worth of taxable account dividends... so between cash, taxable account dividends and pension you can pay for your $50k living expenses for 2 years.

I was thinking $60,000 also but then perhaps over thought it. If the market didn't tank 30% and I didn't have cash I would sell $30,000 in stock each year. So really I only need cash to cover the amount I am short $9,000 each year or $18,000 for two years. I would sell the same number of shares whether the market tanked or not right (by having the cash)?

Also why does it matter if the dividends are in a taxable account or not. I treat all the accounts as one for this type of thing.

 

[evilanne]

Deferred retirement account is taxed as ordinary income. Taxable account is taxed at short or long term capital gains, the latter is typically 0% or 15% depending on what your marginal tax rate is.

 

[pb4uski]

...Also why does it matter if the dividends are in a taxable account or not. I treat all the accounts as one for this type of thing.

Because taxable account dividends are income whether they are taken in cash or reinvested.... if you take tax-deferred dividends in cash then that is a distribution that creates taxable income when it is not necessary to do so.

 

[RetireAge50]

I understand the tax part. I agree with you dividends reduce the need for so much cash. I think this is true regardless of the type of account. They can be reinvested (or kept as cash) within the tax deferred account.

I'm planning to keep most of my cash in a stable value fund in a 401k. When I need cash I will sell stocks in my taxable account while while at the same time buy the same stocks in the 401k. Hope this makes sense.

 

[Scuba]

+1
The value of being liquid when the paycheck stops can not be overestimated. Also suggest looking at your asset allocation as well to ensure you can ride out any declines without selling equities in a down market to support yourself.

+1
The idea is to have enough cash to fully fund your necessary spending for 2-3 years without selling any assets in a down market. Personally I would go with 3 years so that stocks have time to recover after a market dip.

 

[donheff]

I was thinking $60,000 also but then perhaps over thought it. If the market didn't tank 30% and I didn't have cash I would sell $30,000 in stock each year. So really I only need cash to cover the amount I am short $9,000 each year or $18,000 for two years. I would sell the same number of shares whether the market tanked or not right (by having the cash)?

Also why does it matter if the dividends are in a taxable account or not. I treat all the accounts as one for this type of thing.

If you set aside enough cash to add to your spending such that you liquidate the same number of shares you would otherwise have liquidated to cover your spending then all things are not equal. In a good market you are spending X shares. In a bad market you are spending X shares + set-aside cash. You are still in effect buying high and selling low. The concept of a cash cushion is that you liquidate some equities to cash at a high (or relatively high) point and spend it when equities are at a low point. There is no free lunch since the cash may sit around for a long time earning next to nothing so the resulting mileage may vary. An alternative, of course, is to keep a mix of bonds and cash and turn to the bonds when the equities tank. Of course the bonds may be down a bit too... It's complicated.

 

[RunningBum]

I was thinking $60,000 also but then perhaps over thought it. If the market didn't tank 30% and I didn't have cash I would sell $30,000 in stock each year. So really I only need cash to cover the amount I am short $9,000 each year or $18,000 for two years. I would sell the same number of shares whether the market tanked or not right (by having the cash)?

Also why does it matter if the dividends are in a taxable account or not. I treat all the accounts as one for this type of thing.

Ideally you wouldn't sell any shares at a market low in a 30% drop. That way when (if?) the market recovers you portfolio fully bounced back. Run some numbers in a spreadsheet and you'll see.

On the other hand, if that 30% drop doesn't come, or at least not for quite a while, you've missed participating in the market with some of your money.

 

[Looking4Ward]

On the other hand, if that 30% drop doesn't come, or at least not for quite a while, you've missed participating in the market with some of your money.

Rather than cash, I keep 3-4 years worth of expenses in Wellesley for that very reason. It still has the potential to drop during a market crisis but historically has not done so as much or for as long as many other funds.

 

[pb4uski]

I understand the tax part. I agree with you dividends reduce the need for so much cash. I think this is true regardless of the type of account. They can be reinvested (or kept as cash) within the tax deferred account.

I'm planning to keep most of my cash in a stable value fund in a 401k. When I need cash I will sell stocks in my taxable account while while at the same time buy the same stocks in the 401k. Hope this makes sense.

That makes perfect sense to me. I wish I had a stable value fund in my 401k... it didn't so I rolled it over to a tIRA better investment choices.

 

[Huston55]

OP-

I recommend a mix of the advice above.

- Keep 3 yrs x $30k cash (CD)/ST bond fund; I like 2yrs/1yr mix
- Keep it in your taxable account(s)
- Your first reaction to a severe market downturn is to cut expenses (how you do this is as individual as each of us but, it will stretch your cash)
- Don't sell equities (or use dividends); let them recover (along with reinvested dividends)
- In your example, you're "spending" 3% of your NW, which should be relatively "safe" for 30+ yrs
- Change your AA if you're not comfortable

Our plan is somewhat similar to this, and we have further back-ups if required.

 

[ERD50]

+1
The idea is to have enough cash to fully fund your necessary spending for 2-3 years without selling any assets in a down market. Personally I would go with 3 years so that stocks have time to recover after a market dip.

But this is exactly the opposite of what happens when you follow the general plan of selecting an AA and rebalancing when it gets out of whack. It simply doesn't work like that.

If you have a 70/30 AA for example, first, you are getting divs that will make up most of your WR, so that cuts the amount you ever need to sell. Second, if stocks are down, rebalancing tells you to sell from your fixed income to rebalance, not from the equities. You would go a very, very long time before you ever sell stocks in a down market.

I just covered it here as well:

http://www.early-retirement.org/for...est-in-bonds-long-term-86828.html#post1883602

-ERD50

 

[Markola]

ERD50, you make several good points and did the math about dividends and rebalancing vs. cash that I've wondered about. For me, the opportunity cost of having years' worth of cash sitting idle and, worse, be eaten by inflation, is a higher cost than the risk of having that cash invested in bonds. It would be interesting to see a historical comparison of the spending power of 3 years cash sitting in bonds during bond market ups and downs vs. 3 years cash facing inflation. My guess is, one would usually have been better off having the money in bonds. Even when diversified bond funds fall, they don't fall much and recover quickly. I do appreciate that folks have to sleep at night and some sleep better with a big pile of cash, while I sleep better knowing my money is on the job 24-7 all around the globe while I snooze.

 

[Sunset]

ERD50, you make several good points and did the math about dividends and rebalancing vs. cash that I've wondered about. For me, the opportunity cost of having years' worth of cash sitting idle and, worse, be eaten by inflation, is a higher cost than the risk of having that cash invested in bonds. It would be interesting to see a historical comparison of the spending power of 3 years cash sitting in bonds during bond market ups and downs vs. 3 years cash facing inflation. My guess is, one would usually have been better off having the money in bonds. Even when diversified bond funds fall, they don't fall much and recover quickly. I do appreciate that folks have to sleep at night and some sleep better with a big pile of cash, while I sleep better knowing my money is on the job 24-7 all around the globe while I snooze.

Put your 3 yrs of cash in 5 yr CD's currently pay 2.25% which is higher than inflation and you get back 100% of your money.
If you need to cash the CD early , there is a 6 mo penalty, so depending on when you cash it, your real return rate would be 1.3% -> 1.9%, so break it up into maybe 10 CDs so you only break what is needed each year.

 

[audreyh1]

One thing is I look at spending after taxes, which reduces the amount needed in a cash cushion. Mine is set up to supplement lower income from a reduced portfolio. I have a little over a years expenses - about 1.25x - which I have calculated could help me survive a very long run without having to cut back horribly on spending. This is in addition to the current year spending funds I pull out each Jan. The cash cushion funds are invested in 3% CDs, so they aren't just idle and losing to inflation. I actually have accumulated a lot more short-term funds than that, but the remainder I can spend whenever I want.

I would still be drawing from and rebalancing the portfolio. If equities were hit hard, draws would be coming from fixed income at first, even after rebalancing. So I don't worry about selling equities when they are down since I am ~55% equities. Rebalancing trims equities when they are high, not low.

 

[Cobra9777]

...If you have a 70/30 AA for example, first, you are getting divs that will make up most of your WR, so that cuts the amount you ever need to sell. Second, if stocks are down, rebalancing tells you to sell from your fixed income to rebalance, not from the equities. You would go a very, very long time before you ever sell stocks in a down market...

+1

I started off holding 5% cash in the AA, mainly because so many people on this forum and elsewhere extolled the benefits. I never really thought it through until a couple years later. In our case, 2 pensions and rental income cover 65% of spend. The remaining 35% currently represents roughly 2.0% WR (pre-SS). Our portfolio yields 2.9%. Granted, we only take cash dividends from taxable, so we do have to sell shares to close the gap. However, we reinvest in tax-deferred and those reinvestments are purchasing shares that more-than-offset anything we sell in taxable.

Holding all that cash was pointless and I've now reduced it to zero except for a small amount of operating cash to buffer against once-per-year items like property tax, insurance, and international travel.

As ERD50 posted, even for someone with a 3.5% WR, you should be yielding at least 2.5%. So even in a sharp, extended downturn for stocks, you will be selling bonds to generate that 1% gap. Even if you technically sell stock in taxable, when you rebalance in tax-deferred, the net effect is you will have sold the higher returning asset class... in this case bonds, not stocks.

I think holding cash is a needless drag on portfolio performance. Small in any given year, but the cumulative effect over 30+ years can be significant, although probably not a game changer unless your plan is already squeaky tight. Some argue that the impact is inconsequential and thus it's worth it for the emotional sense of security that cash provides. I have no issue with that so long as the investor understands that they are paying a small price for an emotional payback, not financial.

 

[Oneparkatatime]

Sunset +1 That is exactly what I have. I think it's a total of 15+ CDs and I treat it as part of my bond allocation. At 2.25% it's not far off bond fund yield with no underlying risk.


Sent from my iPad using Early Retirement Forum

 

[samclem]

If you have a 70/30 AA for example, first, you are getting divs that will make up most of your WR, so that cuts the amount you ever need to sell. Second, if stocks are down, rebalancing tells you to sell from your fixed income to rebalance, not from the equities. You would go a very, very long time before you ever sell stocks in a down market.

Right. I understand (and still psychologically cling to) the idea of having a cash buffer to avoid selling equities when they are down, but mathematically, it makes zero sense if you'll be rebalancing anyway. (And we know we should be!)

With more words and pretty graphs: Nov 2014 Kitces

 

[rayvt]

Ideally you wouldn't sell any shares at a market low in a 30% drop. That way when (if?) the market recovers you portfolio fully bounced back. Run some numbers in a spreadsheet and you'll see.

Yeah, well ...... I ran some numbers in a spreadsheet.
And it doesn't work.

https://www.dropbox.com/s/xf4ma5blug27aws/SPY_Withdraw_by_CashBucket_rules.xls

There's two problems. One is, if you spend from your 2-year cash bucket in a declining market, what do you do when your cash bucket is empty and now you HAVE to sell stocks when they are deeply down? Suddenly, you wish that you had sold 10% down a year ago instead of having to sell today at 30% down.


The other is, you need to have a way to refill the cash bucket when the crisis is over. Everybody just does a handwaving explanation, but when you run actual hard numbers, nothing works.

 

[urn2bfree]

Yeah, well ...... I ran some numbers in a spreadsheet.
And it doesn't work.

https://www.dropbox.com/s/xf4ma5blug27aws/SPY_Withdraw_by_CashBucket_rules.xls

There's two problems. One is, if you spend from your 2-year cash bucket in a declining market, what do you do when your cash bucket is empty and now you HAVE to sell stocks when they are deeply down? Suddenly, you wish that you had sold 10% down a year ago instead of having to sell today at 30% down.


The other is, you need to have a way to refill the cash bucket when the crisis is over. Everybody just does a handwaving explanation, but when you run actual hard numbers, nothing works.

What should work is considering the cash as an ultra short bond and spending to balance/rebalance.
Example 58% Stocks, 35% bonds, 7% cash or equivalents (e.g. CD's).
Start with a $1000000 portfolio:
You spend dividends and sell shares as needed to keep the proportions the same and for simplicity's sake let's say that the spend is the dividend rate.(about 2%) which leaves you stable after a year at $1 Million portfolio so allocated. Then...
Portfolio takes a hit. Stocks tumble by 40%, bonds fall 3%.
Now stocks are $348,000, about the same as bonds, $339500, cash is $70000 still. Total portfolio is down so that the cash is making up a higher percentage, so you spend cash and sell bonds to total of $20,000 (mostly cash) and buy stocks to restore the proportions. Allow dividends to reinvest at same time.
Thus cash is maintained at 7% of the portfolio and always spent/ added to to keep the AA the same.

 

[samclem]

What should work is considering the cash as an ultra short bond and spending to balance/rebalance.
Example 58% Stocks, 35% bonds, 7% cash or equivalents (e.g. CD's).
Start with a $1000000 portfolio:
You spend dividends and sell shares as needed to keep the proportions the same and for simplicity's sake let's say that the spend is the dividend rate.(about 2%) which leaves you stable after a year at $1 Million portfolio so allocated. Then...
Portfolio takes a hit. Stocks tumble by 40%, bonds fall 3%.
Now stocks are $348,000, about the same as bonds, $339500, cash is $70000 still. Total portfolio is down so that the cash is making up a higher percentage, so you spend cash and sell bonds to total of $20,000 (mostly cash) and buy stocks to restore the proportions. Allow dividends to reinvest at same time.
Thus cash is maintained at 7% of the portfolio and always spent/ added to to keep the AA the same.

Yes, that's all true (as explained in the Kitces link earlier). But doing things this way is not the "cash bucket" as generally understood. If a person is going with the "buckets" approach, they would not use their cash to buy more stocks when they are down (if withdrawals were not enough to rebalance the portfolio, as you described), they would hold on to the remaining cash to support withdrawals in the following year (to forestall/prevent having to "sell stocks when they are down.")

As Kitces points out, if we continue to rebalance faithfully, then the "cash bucket" is a mirage. However, it can be a useful mirage if it helps people stick with a plan.

 

[Fedup]

I know in the past, if I didn't have a large HELOC that I know I could feed my family for 10 years, I might have done something really stupid and regret later on.

 

[jazz4cash]

I know in the past, if I didn't have a large HELOC that I know I could feed my family for 10 years, I might have done something really stupid and regret later on.

I have a HELOC but I assume the bank will freeze it if things are like 2008-9. I don't expect we will see another crunch like that but I figure it will only help if I draw on it before things blow up.