A cash reserve is a cash buffer (sometimes called a bucket or wedge strategy) for retirement expenses in lieu of drawing those expenses directly from your investment accounts. It is a popular belief in the advisor community that a portfolio should have a cash reserve to reduce the risk of having to sell investments during market lows to meet spending needs and to avoid what is called sequence of returns risk (more on sequence of return risk in a future blog post).
With evidence from a financial perspective pointing to a cash reserve strategy being suboptimal, retirees should instead concentrate on proper portfolio design. Nonetheless, it is entirely reasonable from a behavioral perspective to have enough (or as little) of a cash reserve to feel less stress and allow you to sleep easier at night, especially when markets are falling.
For some, this may mean holding next to no cash reserve. That is, they are confident that their portfolio design and carefully planned mix of stocks and bonds with automated rebalancing that uses a total market return approach will yield the desired result. They take comfort in this backed by evidence based studies that confirm their approach. They know they will not panic sell in a downturn.
For others, this may mean holding a year, or two, or maybe even more, of cash reserves. They worry about a market downturn and knowing they have a cash cushion to sustain them brings them comfort - maybe to the point where they rarely even check their investment returns.
For a third group that falls somewhere between, holding some cash, say, six to twelve months worth, may seem to be a reasonable middle ground.
What does the financial planning community say?
The general rule of thumb in the financial advisor community is that in retirement you should have one to two years worth of expenses held in cash or cash-like investments (such as savings accounts). If you Google "retirement cash reserve", that's the result you will get too. The idea here is that by having a cash reserve, often referred to as a "bucket" or "buffer" or "wedge" strategy, that cash might help sustain you should there be an extended downturn in the stock and/or bond market.
Now, let's be clear on what "one to two years worth of expenses" might mean. These are generally considered expenses in excess of those covered by regular income sources such as pensions (company pensions, CPP, locked-in-retirement accounts, etc.) and other regular income streams like old age security (OAS) and employment income. For example, let's say your annual expense budget is $80,000 (including an allocation for income taxes) and you currently get $14,000 per year in CPP and $8,000 per year from a LIRA. One year's worth of expenses in cash would then be $80,000 - $14,000 - $8,000 = $58,000.
On the surface, this seems intuitive. The stock market is down, and so are my investments, so why sell those investments now to generate the cash I need when I have a nice juicy cash reserve to draw from until the markets bounce back?
What does the financial research say?
There is some empirical support for this rule of thumb. In their paper The Benefits of a Cash Reserve Strategy in Retirement Distribution Planning, Shaun Pfeiffer, John Salter, and Harold Evensky conclude that "Results indicate that plan survival rates of the CFR [cash flow reserve] strategy are up to as much as 6 percentage points higher than the plan survival rates for the RDCA [Reverse dollar cost averaging] strategy at the 30-year mark in retirement. The survival advantage of the CFR strategy is complemented by potential behavioral advantages, such as the clients’ increased willingness to tolerate volatility associated with the investment portfolio (IP)."
However, this study from 2013 considers account transaction costs which, given the single ticket asset allocation ETFs and low-fee discount brokerages available today do seem high. In addition, the paper uses a forward looking and conservative estimate of returns versus use of historical actual return rates. This may have the effect of dampening equity returns and mitigating the negative effects of holding cash cited in the studies below.
The study Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies, reveals that having a chunk of your portfolio in cash actually creates a less sustainable retirement portfolio in almost all cases. Per the research paper, it seems that holding cash in reserve creates a long term drag on a retirement portfolio that would otherwise be fully allocated to some combination of stocks and bonds. The study does concede "that the use of a buffer zone may be merited if it will impact one’s investment portfolio choice. To elaborate, it may provide a psychological mechanism to induce clients to accept stock exposure." (bold and italics are mine).
Also contradicting the first study, The Bucket Approach for Retirement: A Suboptimal Behavioral Trick? by Javier Estrada states "Although this strategy is not devoid of merit, the comprehensive evidence discussed here, from 21 countries over a 115-year period, questions its effectiveness. In fact, simple static strategies, which by definition involve periodic rebalancing, clearly outperform bucket strategies, and they do so based not just on one but on four different ways of assessing performance."
Overall, the evidence points to having a cash reserve in retirement is a suboptimal strategy.
What do the mental health professionals say?
Not surprisingly, and consistent with the conclusions from the financial research, there is a correlation between mental well-being and having a cash reserve.
In a survey recently conducted by Telus Health as part of their Telus Mental Health Index, they found a direct correlation between positive worker's mental health and emergency savings and cash cushions.
Likewise, in a recent survey conducted by the Financial Consumer Agency of Canada, not only are financial behaviors and habits linked to psychological well being, the survey results "tell us that Canadians stand to benefit from strategies that would allow them to build more buffers into their spending plans and be better prepared for financial setbacks".
So what does all of this mean?
From a purely financial perspective, having a cash reserve is a suboptimal strategy. It is more important for retirees to focus on proper portfolio design. Nonetheless, it is reasonable to consider how it makes you feel to hold some amount of cash reserve. In other words, and if your financial plan can support it, have enough (or as little) of a cash reserve that makes you feel good and allows you to sleep easier at night, especially when markets are falling.
Comments
Post a Comment