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How Retirees Should Assess Their Liquid Assets

Christine Benz
Thinkstock

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Cash: It’s the asset class investors love to hate. Even as a declining interest-rate environment has helped both stocks and bonds deliver decent returns over the past decade, poor cash investors have had to settle for ever-lower yields. Today, money market yields are barely positive, and even higher-yielding cash options like high-yield savings accounts won’t likely keep up with inflation over the long run. Nor are cash yields likely to get appreciably better any time soon, as the Federal Reserve has telegraphed its intention to move slowly on rate hikes, lest it disrupt a not precisely booming economy.

But even though cash looks like a big “why bother?” today, it remains an essential ingredient in all financial plans, including those of retirees. Not only can it help meet unplanned expenses, which occur in retirement just as at other life stages, but it can also help on the peace-of-mind front. A cash component is the linchpin of “the bucket strategy” for retirement portfolios, enabling retirees to tolerate the fluctuations that will accompany the stock and bond components of their portfolios. And given that market valuations aren’t especially cheap today, opportunistic investors may also like the idea of maintaining some “dry powder” that they can put to work in beaten-down assets, whether stocks or bonds.

Yet even as cash provides stability and liquidity, low yields are an opportunity cost, so it’s important to not go overboard. If you’re retired or getting close to retirement, here are some key steps to take as you assess the liquidity component of your portfolio.

Step 1: Reassess Your Emergency Fund
Given that one of the key reasons to hold an emergency fund is to tide you over in case of unexpected job loss, it may not seem necessary to maintain an emergency fund once you stop working. But at least some type of an emergency fund remains essential in retirement, too, in that it can allow you to cover large, unexpected expenses without having to raid your long-term assets. Think new cars, new roofs, big vet or dental bills, or emergency calls to aid family members.

Just how large your in-retirement emergency fund should be depends on your personal circumstances. What “lumpy” expenses have tended to catch you off guard in the past? What new ones could crop up in retirement? In a past Morningstar.com Discuss forum thread, summarized in this article, many posters said that dental bills were the biggest cost that surprised them in retirement. And despite Medicare Part D coverage, pharmaceutical costs can represent another big-ticket, out-of-pocket outlay for many retiree households. (Of course, if you have a recurring prescription expense, it’s wise to factor that into your household budget and find the Part D plan that best covers the prescriptions that you take.) If you own a home (especially an aging one) and are on the hook for ongoing maintenance costs, that argues for a larger emergency fund than if you’re a renter; people who own cars or have pets are also likely to have unplanned outlays from time to time. It’s also a fact of life that financially healthy family members are sometimes asked to help adult children or siblings who are in a financial bind; if you’ve been a financial savior for your relatives in the past, you could find yourself in that spot in the future, too.

Step 2: Consider the Bucket System
In addition to setting aside an emergency fund, retirees may also want to consider a cash component as part of their long-term portfolios. The virtue of that cash “bucket” is that in difficult market environments, either for stocks or bonds, the retiree can leave the long-term portfolio components undisturbed and in place to recover. That makes sense from an investment standpoint, and can also provide valuable peace of mind in turbulent market environments like 2008. The retiree can spend from bucket 1 on an ongoing basis, periodically refilling it with income distributions or rebalancing proceeds. Alternatively, the retiree can leave the cash undisturbed, to be spent only in catastrophic situations when income distributions and/or rebalancing proceeds are insufficient to meet living expenses in a given year.

But holding too much cash in bucket 1 can drag on a portfolio. Thus, I’ve typically recommended that investors hold anywhere from six months’ to two years’ worth of living expenses in cash instruments; in my recent discussion with financial planner Harold Evensky, the architect of the “bucket” approach to portfolio planning, he suggests that holding one year’s worth of living expenses in cash is a good rule of thumb.

Step 3: Identify Next-Line Reserves
In addition to lining up cash to serve as your emergency fund and supply living expenses in case of a downturn in your long-term portfolio, it’s also valuable to identify “next-line reserves” in case your cash runs dry. In my model bucket portfolios, for example, I’ve stairstepped the portfolios by risk level: In addition to cash, I’ve maintained exposure to a high-quality short-term bond fund. If, in a catastrophic market environment the cash in the portfolio runs dry, the short-term bond fund could be tapped in a pinch; even in a terrible market environment, such a fund is unlikely to incur steep losses. For retired investors who forego cash/bucket 1 as part of their investment portfolios, identifying next-line reserves is essential.

Retirees might also consider home equity as a source of liquidity in a pinch. This article discusses the idea of maintaining a “standby reverse mortgage” to help a retiree limit the opportunity cost of cash while also maintaining access to liquidity during a downturn in the investment portfolio.

Step 4: Maximize Yield--to a Point
True, it’s hard to get excited about earning 1% on anything, and that’s about as high a yield as you’re apt to get on cash accounts today. But look at it this way--1% of $100,000 is $1,000, whereas 0.25%--the yield on some lesser-yielding cash accounts--is just $250. That $750 differential could be a month’s worth of groceries, or a two-night stay in a luxury hotel. Depending on the amount of cash you’ve set aside, it’s worth your while to shop around for the best yield you can find. Today, online savings banks will tend to offer the best combination of decent yields and FDIC protections. And the more you invest, the more attractive your yield is apt to be. Thus, it can be a good idea to consolidate your cash holdings into a single receptacle, if practical.

Stable-value funds, discussed here, are another way to earn a higher yield than true cash instruments, and may prove especially valuable when there's a more meaningful yield differential between cash and intermediate-term bonds. While stable-value funds court more risks than true cash instruments, they've historically been quite safe. You can only find stable-value funds within company retirement plans, though, so to maintain access to them, you'd need to leave assets behind in your plan rather than rolling them over to an IRA.

Retirees will want to be careful about reaching too far for yield, however. While some cash alternatives do promise a higher yield than does true cash, they might give up something in exchange--liquidity, stability, or both. This article discusses how to evaluate the trade-offs of cash alternatives.