How Much Cash Should Retirees Hold?

How Much Cash Should Retirees Hold?

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There is a lot of information available on how much of a retirees portfolio should include of stocks and bonds but when it comes to cash, the information is almost non-existent (for the purpose of this article, I am defining cash as money held in a bank or credit union and covered by FDIC or NCUA insurance). Interested, I went in search of answers and found some good advice that can guide any retiree when thinking about the cash component of their saving and investing plan.

Several months ago I wrote an article providing some guidelines on how much of a person's assets should be in cash. After writing the article, I began to ponder the question in even greater detail, especially as it relates to retirees. 

There is a lot of information available on how much of a retiree's portfolio should be comprised of stocks and bonds, but when it comes to cash, the information is almost non-existent (for the purpose of this article, I am defining cash as money held in a bank or credit union and covered by FDIC or NCUA insurance). Interested in learning more, I found some good advice that can guide any retiree when thinking about the cash component of their saving and investing plan.

I first spoke with Phil Demuth, a frequently consulted investment advisor to high net worth individuals. He is a contributor to Forbes and is the founder of Conservative Wealth Management LLC. In Phil's opinion, cash has two functions:

One, it allows holders peace of mind and the ability to sleep soundly. This is especially true in difficult economic times (think back to 2008). Two, cash provides individuals with flexibility so that they do not need to sell volatile assets when prices drop and they can maintain liquidity in a bear market. Cash also allows individuals to take advantage of buying opportunities when the market is down. Individuals with lots of cash do not need to panic in hard times. 

The downside of cash is the opportunity cost. Money invested in an FDIC insured account paying 1% APY is losing ground when the stock market goes up 10% or more in a year. Several other investment advisors I spoke with didn't like the idea of including cash in a retirement portfolio. David Houle, CFA from Seasons Investments stated that: 

 "In my opinion there's very little reason to hold cash in a retirement portfolio, especially given the low yields to be had on cash holdings. What's implied by the term "portfolio" is that it's the pool of savings that have been set aside to be invested for capital gain and income. That money, in general, should remain fully invested in assets that are going to generate a return. There are periods of time where one might want to hold cash temporarily for tactical reasons, but this is different than carving out a permanent allocation dedicated to cash."

 Ilene Davis, a Certified Financial Planner echoed David's comments, saying:

 First, to clarify, what some people consider their "retirement portfolio" are the qualified plans they have. A true retirement portfolio should include anything that is likely to be liquidated to provide funds through the retirement years.

Therefore, instead of focusing on a percentage that should be in cash, I would recommend that the focus be on how many months of expenses, plus emergency fund, should be in cash.

Brian Frederick, a CFP from Stillwater Financial Partners told me that:

The cash portion of a portfolio depends on someone’s age and what their work status is. For people in retirement, I typically like to see one to two years of living expenses held in cash or CD’s as it will provide a risk free source of money if they need to tap into it unexpectedly. For people still working, I encourage them to have 3-6 months of cash set aside for emergencies. Ideally, this would be in a separate bank account but I’ve also had clients do it inside of a Roth IRA if that’s their only money.

He continued to say:

Interest rates fell off a cliff around Thanksgiving 2008. As a result, cash should be viewed more as a safety net than an income producing asset class. The other side of the coin is that it is dangerous to reach for yield by using bonds – bond prices go down when interest rates go up. Most bond funds this year have lost money as a result of interest rates going up in May & June.

So does cash belong in your portfolio or is it just a part of your emergency fund? Unfortunately, there is no one formula to determine how much of an individual's net worth should be held in cash. It depends on how you think about investing and also your own emotional thresholds and risk tolerance.

Almost all of the experts agreed that at a minimum, those in retirement should have at least 3-6 months of living expenses in cash, while many think that 1-3 years is more appropriate.

Lower Risk Tolerance

Beyond this emergency fund, if you believe, as the famous investors Benjamin Graham and Warren Buffet do that cash is king, then you should set some aside to buy low, when everyone else is heading for the exits. This is exactly what Warren Buffet did in 2008, getting bargain prices on Goldman Sachs and other distressed companies and assets. Cash should also be part of your portfolio if you lose sleep every time the market dips. Peace of mind is itself a valuable asset. The percent of your portfolio you hold in cash will depend on the net worth of your assets, your income needs, and a variety of other factors. Mr. Demuth did caution that investing in bonds is not a substitute for cash. While some short duration, high quality bonds may approach cash in their risk profile, bonds can lose value and some can even default.

Higher Risk Tolerance

If you believe that markets will not crash during your retirement, market volatility does not bother you, you have enough wealth to weather a potential loss in assets, or you want to get the highest yield on your assets, then you should limit your cash to an emergency fund to cover living expenses for a certain period of time.

A qualified investment advisor will be able to listen to your need and design a suitable portfolio.

For the cash that you do hold, make sure you are maximizing its return by getting the best possible rate. BestCashCow's rate tables provide the most competitive rates on savings, CDs, and other FDIC insured or NCUA insured bank and credit union accounts.

You can also use our Savings Booster Calculator to see how much extra income you can earn by switching to a high yield FDIC account.

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Bank Saver Update - Impact of Shutdown on Deposit Rates

Bank Saver Update - Impact of Shutdown on Deposit Rates

Rate information contained on this page may have changed. Please find latest savings rates.

Short them CD and online savings accounts continue to fall while longer-term CD rates continue their climb, even in aftermath of the budget standoff and threat of default. The rise in longer-term rates is good news and shows that bankers expect rates to continue to rise and consumers are demanding more yield to lock their money up for an extended period of time.

Short them CD and online savings accounts continue to fall while longer-term CD rates continue their climb, even in the face of the budget standoff and threat of default. The rise in longer-term rates is good news and shows that bankers expect rates to continue to rise and consumers are demanding more yield to lock their money up for an extended period of time.

From one month ago, 12 month average CD rates decreased by two basis point from 0.351 to 0.349% APY. After increasing before the budget battle, average 3 year CD rates dropped from 0.715 to .714% APY. Five year average CDs continued their march upward, moving from 1.073% to 1.079% APY, up from their low of 1.049% APY in June. The biggest loser over the past month have been online savings account average rates, which fell from 0.681% to 0.664% APY. Online savings accounts have been the bright spot of the last couple of years, retaining relatively high rates even while CD rates crashed. Short term savings vehicles like online savings accounts and one year CDs continue to fall, showing that in the short-term, banks believe rates will stay low.

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The chart below shows the trend in average rates since October 2012.

Top Rate Recap

During this period, top savings and CD rates stayed pretty much status quo.

  • Online Savings: GE Capital Bank retains the top spot at 0.90% APY.
  • 1 Year CD: Nationwide Bank holds the top spot at 1.06% APY with a $100,000 minimum balance. GE Capital Bank is right below it with a 1.05% APY rate and a smaller $500 minimum balance.
  • 3 Year CD: Pentagon Federal Credit Union has taken the top spot with a 1.51% APY CD. Last month, the best rate was 1.50% APY from Salem Five Direct.
  • 5 Year CD: iGoBanking.com continues to offer a 2.05% APY CD.
  • Rewards Checking: Hope Credit Union and Money One Federal Credit Union both have the top rewards checking rate of 3.01% APY for balances up to $10,000. Both credit unions are open to members from across the country.

It's possible to find even better rates at local banks and credit unions (especially for CDs). You can search for better local rates here.

Online Saving and CD Spread

The difference between average 1 year CD rates and average online savings rates continued to decline from the high it achieved in May 2013. On average, online savings account rates pay 0.315 percentage points more than 1 year CDs, up from 0.23 percentage points more at the beginning of last year but down from the spread's high of 0.344 percentage points in May. In addition to paying more than 1 year CDs, online savings rates pay almost the same as 3 year CDs. Despite the fact that online savings rates have lost some ground to 1 year and 3 year CDs, in a rising rate environment, it makes more sense to stay liquid with an online savings account than to lock money into a low rate CD. If the spread declines dramatically then this may be worth revisiting.

General rate environment

As I wrote on the eve of the government shutdown:

"The shutdown provides another tailwind to an economic recover, slowing the economy, and depressing both deposit and borrowing rates. The longer the shutdown, the stronger this tailwind."

Consumer confidence took a significant hit from the government's, with the guage taking its most significant downturn since the collapse of Lehman Brothers in 2008.

Standard and Poor estimated that the shutdown cost the United States $23 billion. The combination of the drop in consumer confidence and the hit to the economy have slowed growth. All of this serves to prolong the Fed's bond buying and the low interest rate environment we are currently in.

In the past, I've identified 4 factors that will impact the timing and scope of interest rate increases:

  • Government & Taxes
  • Europe's economic future
  • Technology
  • General economic baselines (this encompasses consumer confidence)

Any of these can contribute or subtract from growth. Right now, government policies and employment are acting as a drag on the economy.

Still, despite this bump in the road, all signs point to the economy gaining momentum through the end of this year and into next year. I do believe that this economic upturn is real and that rates will continue to slowly rise from this point (even though the Federal government is doing its best to botch the recovery).

So if we look at the scorecard:

  • Taxes & Government: Increasing - drag on growth. Negative
  • U.S. economic growth: Slow to moderate. A protracted fight on the debt ceiling has hit growth and lowered rates. While this was improving last month this month we'll call it: Neutral.
  • Europe and the world: Europe leaving recession; Japan strong growth; developed world slowing but still growing. Overall, world picture is improving. Positive
  • Technology: Gas prices at the pump coming down and plentry of natural gas for the cold winter months due to fracking and other extraction innovations. Slightly Positive.

My outlook: The government shutdown and default embroglio have taken some wind out of the economies sales. Still, as long as the politicos are not back at it in 3 months the damange should be relatively short. Short term rates will continue to fall for a bit longer even as longer term rates continue to rise. The Fed will increase the Federal Funds rate within the next 14 months. Savings rates will hover in the 2-3% range by the end of next year.

Savings Accounts or CDs?

The data continues to show that opening a savings account is a better bet than a 1-3 year term CD and I expect this to hold through 2013. Online savings accounts have held the line over the past year and even though CD rates have stabilized and ticked up, the premium is still not enough to jusity locking the money away. While the premium for opening a 5 year CD over a 1 year CD has increased over the past six weeks, it is still only at 0.722 versus over 1 percentage point in October 2011. In a rising rate environment, it does not make sense to tie up money for 5 years with only a 30 basis premium.

Is it worth it to go long and open a 5 year? I don't think so any more. I think the 5 year CD rates are just too low and that you'd be better off putting your "safe" money into an online savings account and waiting for rates to rise. I spoke to one banker several weeks ago who said that "no one was investing in long-term CDs." Keep your powder dry.

For money you want to keep liquid, go with online savings accounts. They offer better rates than 1-3 year CDs and athough several banks have dropped rates in the past month, they have still offered decent rate stability over the past year and a half.

Make the best of a tough savings situation in 2013

Yields may be low in 2013 but a savvy saver can boost the return with no increase in rate by rate shopping. By shopping around, a saver can earn an extra half to full percentage point. On $100,000, that's $1,000 in extra cash per year. Remember, even in today's environment, there is competition for your cash.

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JP Morgan Chase Instrument Offers 9% Interest for 15 Years If The Stock Market Does Not Fall and The Yield Curve Keeps Its Slope

JP Morgan Chase Instrument Offers 9% Interest for 15 Years If The Stock Market Does Not Fall and The Yield Curve Keeps Its Slope

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JP Morgan Chase is currently syndicating what may be its most interesting Structured Note offering in years.

I have written about Structured Notes extensively on BestCashCow.com (most recently here; an introduction to and overview of Structured Notes is provided here).  These Notes are effectively bonds issued by the largest US banks (JP Morgan Chase, Morgan Stanley, Goldman Sachs, Bank of America, Wells Fargo and Citibank), and are not FDIC insured.  They can offer investors a yield well above and beyond rates that might otherwise be accessible.   But, in return for the high yields, investors have to accept kill provisions that could result in interest not being paid for long periods (even the life of the bond).   Investors obviously are also taking on significant risks associated with the credit of the issuer, prepayment or call risk, and the risk of investing in an instrument that has no secondary market (no liquidity).

Risks associated with Structured Notes ordinarily outweigh the upside that the issuing bank is offering; it is rare to find notes that are very compelling.  I have found that most notes tied to equities or baskets of equities offer hedge fund-like risk without commensurate return.  I also caution investors to avoid any structured notes tied to exchange rate risk (I personally invested a small amount of money in a Morgan Stanley issued structured note tied to the Brazilian Real a couple of years ago, only to have exchange rates move in a manner that has left my money tied up and earning 1.00% until the note becomes due in 2016).

For this reason, it is particularly rare that I find a Structured Note that interests me, and that happened with a recent JP Morgan offering.  The offering is a 15- year instrument which is not callable by the bank.  It pays 9% in year one and then in years 2 through 15, pays the spread between the 30 year and 2 year Constant Maturity Swap (CMS) times a factor 4, but no more than 9% annualized.  The Note also has a kill provision stating that it will not pay interest for any day in the previous quarterly period during which the S&P 500 traded below 25% of the S&P level on the day of pricing (e.g., were the S&P 500 at 1700 on the pricing date, that level would be set at 1225).

The Constant Maturity Swap (CMS), quoted on Reuters or Bloomberg, is essentially the rate at which banks trade with one another and matches the US Treasury rate very closely.  A 2 year CMS is currently at 0.48% and a 30 year CMS at 3.50%.  Provided that the spread continues to remain above 2.25% on each quarterly measurement date, the Note will continue to yield 9% annually (provided, of course, that the S&P kill provision is not met).  It the spread is some number below 2.25%, the Note will pay an amount four times that spread.  If the spread goes to 0 or if the 2 year CMS rises above the 30 year CMS (i.e., the yield becomes inverted), the Notes will pay nothing for that quarter.

A chart of the 2 and 30 year CMS spread for the last fifteen years indicates that there have been long periods when the spread has been less than 2.25%, during the 2000-2001 recession, between 2005 and 2008, and again in 2011 and 2012.  In fact, the spread narrowed to 0 and was briefly inverted in 2000 and again in 2006.  Nevertheless, as one looks out over the next 15 years,  it would not be unreasonable to believe that while there may be quarterly interest payments over the life of the Note that are lower than 9% or even missed as a result of a narrow spread, the yield curve ordinarily has and holds a slope. 

It, therefore, strikes me that the greater risk associated with these Notes is that the S&P will fall by more than 25% at some period shortly after the Notes are issued and remain there for many years.  Unlike a dividend paying stock which still pays a dividend after a large fall, this instrument basically becomes dead money after a market fall until either the market recovers or maturity is reached.  Since maturity is 15 years away and since the Notes are illiquid, investors could be sitting on this asset waiting for their money for a long period of time.

 Investors need to decide for themselves whether a Structured Note like this one is appropriate for their portfolio.  The Note described above is accessible at CUSIP No. 48126D7K9.  As with any Structured Note, you should carefully read the prospectus and fully assess the associated risks for yourself.  

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