Thoughts on Short-Term Reserves

[Lsbcal]

You can see how cash lowers bond volatility. Not as much as bonds lower stock volatility, of course.

But that graph is missing a key component. It doesn't show the long-term return. Usually when someone picks an AA they are trading off between volatility and long-term return, so you need to see both factors.

There is a nice chart lower down on that page that shows this:

Also this chart of drawdowns of bonds and stocks vividly illustrates their relative volatility:

The later chart is from this blog: One of My Investing Pet Peeves

 

[LOL!]

What does this matter? Why is there something wrong with "keeping cash around"? As long as a retiree has enough invested in stocks and bonds that they are able to withdraw the annual income they need and the portfolio is highly likely to survive long term (so an appropriate AA in the portfolio they are withdrawing from), it doesn't matter if cash accumulates on the sidelines or if they set up a cash buffer separately from their retirement portfolio.

Here is a good read on "What does this matter?"
https://earlyretirementnow.com/2016/10/26/cash-management-in-early-retirement/

I'll summarize for you:

Conclusions:

Don’t get your hopes up too high! A cash cushion is no magic bullet against market fluctuations. I mean, come on, does anybody really believe that an equity portfolio will be down 60% but with a cash cushion of a few % you suddenly keep all your purchasing power? We didn’t and we confirmed our prior belief.

A constant cash cushion is a bad idea. It just creates opportunity cost. No surprise here!

Market timing works – to a degree! And it makes sense! By not selling equities when the market tanks you bet on long-term mean reversion. The market will always recover eventually.

Of course, the cash cushion will likely help if you find yourself right before the market tanks. But I was amazed that even in Dec-1997 and Dec-1998 when the S&P500 still had a very strong subsequent performance in the 1998 and 1999 calendar years, you beat the passive withdrawal strategy of a 100% equity portfolio. I was very surprised about this result! I learned something new and unexpected today!

Nothing is set in stone yet, but we might entertain keeping a bit of a cash reserve, come 2018! We will still do some more research on how robust these results are, but we may scale back our cash-aversion a bit.

It seems that the only way to make a portfolio survive a bad bear market is to drastically reduce spending from it. That means have some leeway in your budgets to reduce withdrawals from 3.5% every year to a bare bones level. What that level might be only you can decide, but maybe 2%?

And yes, I know the link was not testing a 60/40 portfolio (or a 50/50, or a …).

One will be better off over the long term in a [possibly short-term] bond fund.

 

[audreyh1]

Here is a good read on "What does this matter?"
https://earlyretirementnow.com/2016/10/26/cash-management-in-early-retirement/

I'll summarize for you:

It seems that the only way to make a portfolio survive a bad bear market is to drastically reduce spending from it. That means have some leeway in your budgets to reduce withdrawals from 3.5% every year to a bare bones level. What that level might be only you can decide, but maybe 2%?

And yes, I know the link was not testing a 60/40 portfolio (or a 50/50, or a …).

I can't really deal with the author's paper since he is trying to stay 100% invested in equities as a retiree and modeling a cash cushion along with that. I guess the author doesn't like the "drag" of bonds either.

The criticism of holding a big chunk of cash or short term reserves is always "opportunity cost".

But for those with a large investment portfolio, "opportunity cost" may no longer be a major consideration, especially if the focus is more on spending now and spending down. Once the retirement portfolio is large enough to support generous withdrawals and spending, and large enough to survive bad market runs even with diminished withdrawals for a while, what is the point of adding more to it? To have a larger amount when you are older and when you die?

People can speculate how other people might behave and spend once we enter a bear market, but they don't know. Someone who has set aside funds for a certain trip might go ahead and take it even if a bear market happens, or they might be scared out of spending. I've been through two severe bear markets since retiring in 1999 which is why I know my system works for me.

We are truly beating a dead horse here. I, personally, would like some folks to agree that opportunity cost (i.e. maximizing long term investment growth) is not always the number one consideration for someone already retired with a well funded retirement.

It seems that the only way to make a portfolio survive a bad bear market is to drastically reduce spending from it. That means have some leeway in your budgets to reduce withdrawals from 3.5% every year to a bare bones level. What that level might be only you can decide, but maybe 2%?

Well, that's the point. Your withdrawals may drop because your portfolio dropped, but if you have short term reserves outside of your investment portfolio, then you don't have to cut spending drastically, at least for a while. You can gradually ramp down or supplement your spending from reserves, or whatever. You have some choices and time to make them.

If you've put every last penny into your retirement portfolio, and have no emergency buffer and/or have set aside funds for financing some short term plans that require funds, then yes, you do have to cut your spending drastically to ensure portfolio survival, [unless you are on the original Trinity study constant withdrawal method and are able to ignore your shrinking portfolio].

I certainly don't intend to reduce withdrawals from 3.5% to 2% when we hit another bear market. Why would I? My % remaining portfolio models show that I won't have to. I will stay with 3.5% or more as I age. My portfolio income will shrink in real terms, and that's when I can choose to draw on some of my short term reserves to help smooth out the income volatility. I have plenty of discretionary spending, but I don't envision super drastic cuts in spending even during a prolonged bear market.

 

[eytonxav]

I have been holding ~ 4 years living expenses since I have not yet tapped into other income sources like SS and a small pension that DW gets at 65, and have been living off ira funds since our after tax holdings are small. I guess it really depends on your other income sources and how much your mandatory expenses are covered by other income sources. I will cut that down quite a bit as SS and pension kick in.

 

[GTFan]

I think the folks that hold little cash are the same ones that min-max RPGs. Yeah, this is geek humor for those that don't know what I'm talking about.

Agree with audrey that yep there's an opportunity cost with cash holdings, but that it's really irrelevant to most IMO when your invested port is big enough so that it doesn't matter.

 

[Lsbcal]

...
I certainly don't intend to reduce withdrawals from 3.5% to 2% when we hit another bear market. Why would I? My % remaining portfolio models show that I won't have to. I will stay with 3.5% or more as I age. My portfolio income will shrink in real terms, and that's when I can choose to draw on some of my short term reserves to help smooth out the income volatility. I have plenty of discretionary spending, but I don't envision super drastic cuts in spending even during a prolonged bear market.

This sounds good to me. But then see below ...

I ran a VPW simulation to show (to myself) that a buffer would help a lot in a downturn. This is just a back-of-the-envelope simulation on a $1M portfolio split 60/40. I modified VPW for 3.5% withdrawals. The start year 1968 is a particularly bad year because there were 2 recessions (1969 and 1973) during that time plus a lot of inflation in the 1970's.

Below is the simulation result. I think the age 65 to 75 are particularly interesting because active retirees might need more discretionary money then. Suppose this couple needed maybe $30k from the portfolio. You can see there are a lot of years (far right column Total Income) that were well below $30k. So this case would need a lot of buffer money. Also note that the portfolio was cut nearly in half (inflation adjusted balance column) by age 79.

Makes me think I should do more homework on this issue. Hopefully we will not see such a bad sequence.

I'd be interested in what other's think of this simulation.

 

[Sunset]

......
The criticism of holding a big chunk of cash or short term reserves is always "opportunity cost"......

We are truly beating a dead horse here. I, personally, would like some folks to agree that opportunity cost (i.e. maximizing long term investment growth) is not always the number one consideration for someone already retired with a well funded retirement.
.......

I agree, as I will not need to sell if the market drops 50% or 95% (like in the Great Depression).

We are secure with 4-5 yrs worth of cash earning 1% interest.
Obviously missing out on some gains, but sleep pretty easy.

 

[Sunset]

This sounds good to me. But then see below ...

I ran a VPW simulation to show (to myself) that a buffer would help a lot in a downturn. This is just a back-of-the-envelope simulation on a $1M portfolio split 60/40. I modified VPW for 3.5% withdrawals. The start year 1968 is a particularly bad year because there were 2 recessions (1969 and 1973) during that time plus a lot of inflation in the 1970's.

Below is the simulation result. I think the age 65 to 75 are particularly interesting because active retirees might need more discretionary money then. Suppose this couple needed maybe $30k from the portfolio. You can see there are a lot of years (far right column Total Income) that were well below $30k. So this case would need a lot of buffer money. Also note that the portfolio was cut nearly in half (inflation adjusted balance column) by age 79.

Makes me think I should do more homework on this issue. Hopefully we will not see such a bad sequence.

I'd be interested in what other's think of this simulation.

I quickly did the shortfall years, The blue ones in the far right (and it was approx adding).
So it was short by $139,000 , which would be covered by 4yrs worth of cash to make up the shortfall using the $30,000 per year spending.

This is without counting the approximate $13,5xx dollars surplus from the years prior to the blue years.

This seems to confirm for me having a stash of cash available to top up during down years is advisable.

 

[Lsbcal]

I quickly did the shortfall years, The blue ones in the far right (and it was approx adding).
So it was short by $139,000 , which would be covered by 4yrs worth of cash to make up the shortfall using the $30,000 per year spending.
...

My intuitive guess is that maybe 2 years of short term bonds (2 years duration) would suffice, and then dip into the intermediate bonds to fund spending until the hopeful reversion-to-the-mean occurs.

I personally do not rebalance when the markets go down. This is because I fear a scenario where we do not revert to the mean in equities for a few decades. When equities go down and one is spending from FI, rebalancing kind of takes place automatically i.e. equities are going down and so is FI hence less to rebalance anyway.

 

[respond2u]

"My target calls for 6% short-term reserves"
I think about it differently.

I want cash reserves for two reasons:
- some amount based on my annual spending, not on % portfolio, to draw from during recessions when the market prices are low. A typical bear market corrects pretty quickly, but recessions can drag on for 2-3 years. That cash will be in where I'm drawing my living expenses from (soon to be a SEPP program, so the cash is in my SEP-IRA)

- unbudgeted emergencies. I include known unknowns, like car repairs, in my budget and have a slush fund for the more uncertain ones like broken legs or hail storms chewing through my very high deductible. That cash needs to be readily accessible and already taxed so I'm not facing a double-whammy.

In neither case do I target having a specific %age of my portfolio in cash.

--
OTOH, If I had a few hundred million, I'd follow Mark Cuban's advice and keep it all in cash

 

[audreyh1]

This sounds good to me. But then see below ...

I ran a VPW simulation to show (to myself) that a buffer would help a lot in a downturn. This is just a back-of-the-envelope simulation on a $1M portfolio split 60/40. I modified VPW for 3.5% withdrawals. The start year 1968 is a particularly bad year because there were 2 recessions (1969 and 1973) during that time plus a lot of inflation in the 1970's.

Below is the simulation result. I think the age 65 to 75 are particularly interesting because active retirees might need more discretionary money then. Suppose this couple needed maybe $30k from the portfolio. You can see there are a lot of years (far right column Total Income) that were well below $30k. So this case would need a lot of buffer money. Also note that the portfolio was cut nearly in half (inflation adjusted balance column) by age 79.

Makes me think I should do more homework on this issue. Hopefully we will not see such a bad sequence.

I'd be interested in what other's think of this simulation.

I have run scenarios with % remaining portfolio (I have summarized these in another thread) and what happens to income under the worst case historic scenarios.

Most of the worst case scenarios occur before 1920, but 1966 is the worst in the past 50 years. I have looked at how real income reduces, and what kind of supplementation from short-term reserves might be needed. I am using a 50% Total Stock Market, 50% 5 year treasuries portfolio for my model, so the runs will vary a bit from yours. I am also using 3.5% as the % withdrawal rate.

For the %remaining portfolio method, starting in 1966, 3.5% withdrawals got down to 52% of starting income (keeping up with inflation, so real) after 14 years before gradually recovering. But several pre-1920 cases were worse, with a 1906 run taking you down to 47% real income after 15 years before recovering. In both cases we are looking at generally declining income year after year, so you are talking about an extended case of declining income dropping to under 80% after years 8 or 10, and dropping more rapidly thereafter for the next 5 to 8 years before finally turning around. So - yes, under the most extreme scenarios this is very serious. You would need 5 to 7 years of pre-tax income to supplement these scenarios to maintain current spending at 100% real. In practice it would actually not be quite that high though as you only need to supplement your after-tax income assuming your reserves are in taxable funds. So modeling gets a bit more complex, but I would assume 4 to 6 might do it for 15% tax rate, less if your tax rate is higher.

Currently, my pre-tax spending (budget) is less than 80% of the 3.5% I withdraw from my portfolio. So I could suffer a 20% portfolio hit before needing to start dipping into any reserves set aside to supplement the reduced (real) income from our portfolio. We are currently underspending even this budget.

My current budget also includes a great deal of discretionary spending (including gifting), so I can cut quite a bit out without too much pain. I decided to look at a combination of belt-tightening and using reserves for handling a really really bad sequence like 1906 or 1966.

I looked at what kind of belt tightening would be required if I set aside approximately one year of my current after-tax budget as a bear market reserve. Some calculations I used came up with a number 3% above the current budget based on Dec 31 value of my current portfolio. I used a model of not drawing on these reserves until my income dropped to 80% of current income (which would meet my current budget - still 100%), and then being willing to start belt tightening so that my budget drops to 87.5% of current budget if income drops below 70% of current (portfolio down >30% real), and then 75% of my budget if income drops below 60% of current budget (portfolio down >40% real). None of the scenarios I ran required worse belt tightening than that.

The belt-tightening actually won't be as bad because my taxes drop significantly when my assets drop, even going to zero, so my after-tax income won't drop nearly as much as my pre-tax income. But that's another level of refinement, so I didn't model it for these cases. I just know it from experience.

From my modeling, if I weren't willing to do any belt tightening, then I would need to set aside a reserve of around 2 to 2.5 years of my after-tax budget to maintain spending at current levels (real) at 80% of my current withdrawal. So that's certainly a reasonable alternative. I have certainly have more than one year of budget in short-term funds (beyond current year funds), but I chose to only cordon off around one year as "only touch under dire circumstances" and the remainder is available to spend in the near term as I see fit. BTW I was able to move this bear market reserve into 3% CDs recently which will help with maintaining the fund.

I mainly did this to see how much of my short-term funds were truly free to spend now versus how much should be set aside and not touched unless something really bad happened including the portfolio dropping >20% and staying down long enough for us to have reduced our other short-term funds considerably.

 

[Gotadimple]

I have been holding ~ 4 years living expenses since I have not yet tapped into other income sources like SS and a small pension that DW gets at 65, and have been living off ira funds since our after tax holdings are small. I guess it really depends on your other income sources and how much your mandatory expenses are covered by other income sources. I will cut that down quite a bit as SS and pension kick in.

I wanted to get back to this point: creating a reserve of cash to draw on before Social Security and RMD's. What DFW is doing is exactly the method I used before Social Security - I created a cash reserve to cover expenses until I began withdrawing.

I reassessed that reserve annually and decremented the need as I got closer to Social Security. This takes $$ off the table, but assures you have the asset to draw on until income increases. From an overall cash flow view, you have non-taxable income to draw on. Some would leave that in a Roth IRA, my preference was high yield savings/CDs, rather than disturbing the tax-free earnings in the Roth.

- Rita

 

[Lsbcal]

Audrey, I am impressed with your modeling efforts which are very specific to your situation.

We are currently in the 3.3% spending range over the last 4 years. I have to balance this kind of modeling which can be scary with the real need to have fun in retirement.

It seems if there is going to be a really bad sequence ahead, there are only limited ways to avoid the belt tightening. Yes, RMD's will go down (and their tax consequences) if the IRA portfolio takes a hit. But we don't know how government tax policy will behave, maybe it will take the tax savings all back.

Anyway, seems a good thought to have a few years of short term reserves if they are not too big a drag on portfolio performance. It is not too hard (as I did above in one post) to estimate this performance hit. The hit can be mitigated by going for a low ER portfolio approach and other such best of practices. Our ER = 0.08% right now.

 

[jazz4cash]

I have a barbell portfolio with 70% equities and the rest in a CD ladder going out 7 yrs. The weighted return on the CDs is 3.7%. I arbitrarily classify any CD >2yrs as a " bond" giving me a 70/20/10 asset allocation including 3yrs of cash@ 3.3 WR. Another benefit of the CDs is ability to withdraw dividends in case of an emergency. I never really had a cash reserve when working. I could use credit cards or 401k loans if necessary. I can't imagine not having cash reserves in retirement.