We expend much effort, analysis, and research to determine how to maximize the potential of your money. However, money is never the end; it is only the beginning. Your money in and of itself does not have value. Your money has value because you have values that your money helps you achieve. Savings is deferred consumption. One day, you will use your savings and at that point you will reap the true benefit of your wealth.
In this way, although the mathematical prediction for how you can get wildly large investment gains is to have a portfolio invested entirely in appreciation, this is normally not the right answer for many withdrawing families. When a portfolio is burdened with withdrawals, some sequences of returns run out of money during the 30 years. Having everything in stocks risks having to take money out after poor market returns early in the sequence and therefore not having enough money remaining to grow when the markets recover. We believe the best approach for those with spending needs is to include an allocation to more stable investments in the portfolio. The addition of stable investments can help dampen the risk and increase the chances of meeting your spending goals.
Here’s how we recommend doing that:
Checking Account Cash: 2 to 3 Months
We recommend having a sufficient amount in your checking account so that you are never worried that you are going to bounce a check. Usually one member of the family takes responsibility for paying bills and monitoring levels in the checking account.
We often recommend that the other spouse doesn’t spend from the checking account. Instead, they should either charge purchases on their credit card (if they are thrifty) or utilize cash (if they are a spendthrift). This gives the spouse responsible for bill payment the ability to ensure that all bills are paid each month without worrying about a surprise cash flow issue from the other’s spending.
How much cash buffer the financial family member needs in order to feel comfortable that the account won’t be overdrawn varies. On average, we suggest 2 to 3 months of spending. A paycheck might come in at the beginning of the month raising the account value to about 3 months of spending. And by the end of the month the account has fallen to about 2 months of spending.
Some families are able to comfortably run their financial affairs with less than 2 months of spending buffer.
Schwab’s checking accounts can be tied to your brokerage account for free overdraft protection. In fact, they can be structured so that the checking account keeps a zero balance and always draws money from the brokerage account. If the brokerage account does not have sufficient money, the withdrawal in excess of the cash balance sends the account on margin. Currently Schwab’s margin loans are at an effective annual rate of 9.825%. While that is a high rate, it costs less to have a small amount of interest for a short period of time than it does to bounce a check. At current rates, even if you were on $1,000 of margin for a month it would only cost you $8.19. (See “Guidelines for Using Margin” for more information on this.)
Less buffer is needed if you have a checking account which automatically draws from your brokerage account for overdraft protection.
Other families run businesses out of their checking account and feel like they need $100,000 in cash at all times in case they want to bid on an estate sale or make some other large purchase. Keeping large amounts of money comes with lost opportunity costs, and it is important that you realize that between inflation and lost market returns your yearly lost opportunity costs could be as high as 10% of the amount you are keeping in cash.
If you are hesitant to invest because the market is up or down, you are on average losing money. People often allow money to build up in their checking accounts either because of neglect — they don’t know it is there — or because of worry — What if I need it? Often it is left there for months, even years, before it is needed.
Staging Cash Withdrawals in Retirement: 3 to 6 Months
In retirement, instead of a paycheck, you have income like Social Security, Required Minimum Distributions, or a pension. These are sometimes supplemented with cash withdrawals from your investment accounts to meet your spending needs.
We recommend that you structure your cash withdrawals from your taxable brokerage account in a monthly manner that works exactly like a paycheck coming into your checking account. Instead of directly depositing your income sources to your spending account, it is wise to set up a system that curbs your temptation to spend more just because, for example, the IRS made you take money out of a tax-advantaged account.
We recommend that you deposit all of your sources of income into your taxable brokerage account and then only take withdrawals from this account. All of your sources of income will vary in value throughout retirement, but your lifestyle spending should only vary when you deliberately decide to increase it.
Once the links between your taxable brokerage account and your checking account have been set up, cash is available for overnight transfer. Depending on your bank, there may also be a hold placed on money transferred.
For clients who are still earning, money can be transferred from their taxable account to fund their Roth IRAs each year. If you are contributing to your account rather than withdrawing, then your taxable brokerage account can be fully invested and as little as possible kept in cash or bonds.
But for clients who are withdrawing during retirement, we recommend keeping 3 to 6 months in cash to satisfy upcoming withdrawals. Having 3 to 6 months of cash for withdrawals results in having to review your account and generate cash less frequently, perhaps just quarterly. We also recommend having all of your investments pay their interest and dividends in cash rather than automatically reinvesting them. Allowing dividends to be paid in cash requires less trading in the account in order to satisfy regular withdrawals on the account.
Safe Spending in Bonds: 5 to 7 Years
Most of your investments should be in stocks for the long run. But the danger of being invested entirely in stocks during retirement is that you might need to withdraw cash for your lifestyle when the markets are down. Withdrawals from your stock portfolio when stocks are down can result in taking out too great of a percentage of your portfolio. This can jeopardize your retirement plan. For that reason, we recommend that you have at least 5 to 7 years of net withdrawals from your portfolio invested in bonds.
Having 5 to 7 years of net withdrawals invested in bonds is a strategic unemotional purchase of bonds. We don’t think you should buy bonds out of fear. Money that will be spent more than 7 years in the future should be invested in stocks in order to have the best chance to appreciate well over inflation.
If you will have no withdrawals on your portfolio over the next several years, then you do not need to have a bond allocation. If you are not just on track but ahead on meeting your retirement goals, then you may elect to have a bond allocation simply because of a preference towards a less volatile portfolio. However, if you are behind on your savings, you may not be able to afford moving more conservative in your investments unless you lower your annual spending permanently.
Emergency Allocation: 10% of Your Budgeted Spending
Many budgeting websites recommend having some fixed percentage or dollar amount saved for emergencies. The difficulty with budgeting this way is that once you spend your emergency fund, how do you replenish it? We recommend planning on budgeting surprises constantly by setting aside at least 10% of your budget each month for “unknown unknowns.”
None of us can anticipate all of our expenses. The car breaks. The roof leaks. You need to fly to a family funeral. Your daughter gets married. Every stage of life brings a whole new set on unanticipated expenses. Perhaps extensive study and research could have helped you prepare. But it is easier simply to budget 10% for unknown unknowns.
Rather than calling this an emergency fund, it would be more appropriate to call it an emergency allocation.
The first question I usually get asked regarding this category is “Like what?” The truth is that even after identifying every expense you can think of, there will probably still be significant new expenses that may push you toward deficit spending. Every surprise expense is an opportunity to anticipate and plan for that expense in the future. But even so, the timing of many surprise expenses cannot be anticipated.
If you are using the automatic savings technique described above, it is easy to transfer 10% less to your checking account each month and leave behind 10% more of your budget for saving and investing as your emergency fund.
Beyond the known cash flows of your checking account, investment account, and 5 to 7 years of bonds, we recommend that you keep your emergency fund and remaining assets as fully invested as possible. At a 7% rate of return, your emergency fund will double every ten years. Hopefully, you will not have an emergency and instead end the decade with most or all of your emergency fund having doubled.
In the event that an emergency happens, investments can be sold and the cash will be available in two business days after the trade settles. After an additional day the money can be transferred to your checking account. Allowing for a short hold, the money can then be used to pay the emergency bills. All of that might take just over a week. In the meantime, putting the emergency expense on a credit card with no monthly balance buys you a thirty-day interest-free loan.
Families without an emergency allocation all too frequently have their savings wiped out or are sent into credit card debt when some inevitable financial shock hits their family.
Household cash management and cash flow is extremely valuable. Structured correctly and managed well it provides the engine for building significant investment wealth.
Your asset allocation matters to maintaining a balance in retirement of having money for the next 5 to 7 years and keeping up with inflation for time periods of 8 years or longer.
Saving happens best when you aren’t paying attention. Set up your own savings program and put your plan for wealth accumulation on autopilot. Regular systematic saving is one of the seven principles to reaching your retirement goals.
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