One of the first things I did when I started looking after our parents’ money was move a substantial sum from their checking account to an interest-bearing account. When I asked why they had so much sitting in their checking account, they answered, “You never know. We may want to buy a new car.”
For a long time, the conventional wisdom was to keep 20-35% of a retirement portfolio in cash. It was liquid in the case of an emergency and available if a terrific investment opportunity came along. And of course, cash was supposed to be safe.
Today holding cash in the bank or your brokerage account is like a leaky faucet. It leaves your purchasing power going drip, drip, drip. And a bundle hidden under a mattress? Don’t even think about it!
The same conventional wisdom said that a retirement portfolio should grow ahead of inflation by at least 4% annually. A retiree could withdraw 4% for income while keeping a healthy cushion of inflation protection in place. A 6% return got the job done (we’re talking about a pre-2008 universe here).
To keep the math simple, let’s pretend you have a $100,000 portfolio. You’re aiming for 6% ($6,000) growth annually. You plan to live off of 4% and to leave the other 2% to compound and grow.
You’re comfortable holding 30% in cash. In 2007, most savings and brokerage accounts were paying 4% or so in interest. Your cash holdings would generate $1,200 in interest annually. The remaining $70,000 would have to generate $4,800, or 6.85%, to hit your 6% goal.
Enter the Leaky Faucet
Today banks and brokerage firms pay somewhere in the neighborhood of 0.01% interest on cash accounts. So instead of collecting $1,200 per year on your $30,000 account, you get a measly $3. (Starbucks, here I come!)
But wait! Some banks offer a really good deal. Deposit $100,000 and they will pay you $500 or thereabouts in interest. In other words, seniors and savers are penalized for holding cash.
If you keep $30,000 in cash, earning $3, then your remaining $70,000 would have to earn $5,997, or 8.6%, to hit your overall 6% target. Plus, CDs and Treasuries are not particularly helpful alternatives. Right now the best rate for a 1-year CD is about 1.15%; the 1-year Treasury yield is hovering around 0.25%.
That isn’t going to cut it! Most people living on fixed incomes need to update where and how they hold their cash before that leaky faucet turns into an all-out flood.
From Cash to Cash-Like
Holding 30% of your portfolio in safe, liquid, cash-like investments is still the prudent way to go. Retirement investors should risk as little in the market as is necessary to hit their targets.
Here’s how it’s done. Instead of holding the 30% in your brokerage account, hold 30% in safe, liquid, short-term cash instruments that pay higher yields. While they might not yield close to the 6% you’d like, there are still plenty of safe options that yield substantially more than bank or brokerage cash accounts. I’m not talking about unicorns here; solid cash-like investments do exist.
The Risk Trifecta
There are risks, of course, to keep in mind on your hunt. The most important are: default; duration; and beta (market correlation). Let’s look at them independently.
Default risk is the risk of lending money to a borrower unable to pay it all back. To earn a higher yield, you have to take on some default risk. But there are two key ways you can keep this risk to a minimum:
- by buying into a highly diversified, low-cost fund so that no single default would have a major impact on your nest egg; and
- by looking into a fund’s holdings—both the industries they’re involved in and the credit rating (quality) of the debt they hold.
Let’s move on to duration, the sensitivity of a fund’s share price in relation to interest rate changes. A duration of 1 means that for a one percentage point change in interest rates, the fund’s share price is expected to rise or fall by 1% in tandem.
A fund holding 10-year Treasuries with an annual rate of 2.19% and paying coupons quarterly would have a duration of 9.01, meaning that a one percentage point increase in interest rates would cause your share price to drop 9.01%, wiping out several years in interest gains. You would have to either sell the asset at a loss or hold it until maturity while earning below market interest rates. With interest rates as low as they are, you want the lowest possible duration you can find… much less than 1.
Beta indicates the share price of an investment in relation to the market, commonly represented by the S&P 500 Index. Beta shows the relationship between the investment and the “market” over a certain number of years. A beta of 1 means if the market moves up or down by 1%, the share price of the asset will do the same.
The lower the beta, the better. You do not want this portion of our portfolio moving in relation to the market. A beta of 0.001 is very close to zero and means that the investment moves almost independently from the market, or that it has almost no systemic risk.
The ideal investment for your cash-like holdings has minimum default risk and the lowest possible duration and beta; you want it to be independent of the market and interest rate fluctuations.
Do investments like this exist? Absolutely, if you are willing to look… or tap a team to look for you. In fact, a recent addition to the MoneyForever Portfolio fits the bill quite well. While my fingers are itching to type out the name right here, I can’t do that. It would be unfair to our paid subscribers.
Our portfolio keeps to a 30% cash-like allocation—what we call the Stable Income category—for the same reasons our parents held cash (not just in case we want to buy a car). It gives subscribers the liquidity of cash and enough yield that we can hit our investment targets without putting the remaining 70% of the portfolio at undue risk.
I’m saddened when I hear of retirees taking on too much risk because they think they have no other choice. You have options—options that any risk-averse, retirement-minded investor can take without fear of losing the farm.
If you want to learn more about these options, I encourage you to take advantage of our 3-month, 100% money-back guarantee. Sign up for Money Forever for $99 per year (half-off the regular $199 rate) and download my book Retirement Reboot, and all of our special reports. You’ll gain immediate access to the entire portfolio, unique tools to help analyze investment candidates, and all of our archives. If you decide it’s not for you, cancel within 90 days and we’ll refund every last penny you paid, no questions asked. Click here to start your risk free trial now.
On the Lighter Side
I’d like to thank everyone who wrote in after our year-end article. Several folks mentioned that they’d sent it around to their personal mailing lists, and I certainly consider that a compliment.
One gentleman from India wrote to share that in his country, the 75th birthday is considered special, and year 81 is even more significant, since hitting that milestone means you’ve lived to see 1,000 full moons.
I shared his comments with several friends, and we made a pact to get together in 2021 to howl at the full moon.
I’m not one to wish my life away. Each day is there to enjoy. Close friend Dennis A. sent me a cartoon that makes that point quite well.
Don’t forget to follow us on Twitter @millersmoney.
Until next week…