My Cash Strategy During Retirement

14 Oct 2018 16:36
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With early retirement less than 10 years away one strategy I need to consider as part of my investing strategy is how much to keep in cash. Too much and inflation erodes the value and too little could allow an unplanned risk to negatively impact finances so what is the right amount?

The rule of thumb is to have three to six months of expenses in cash. Personally I don’t see this as risk reduction but more as a schedule of when to receive dividend income. My plan is to let dividends build in my brokerage account and then sweep the funds into my checking account to live on every 3-6 months. So how much additional cash should one have in case of emergencies?

During retirement or financial independence, financial experts are quoted in many articles as stating two to three years of expenses in cash and to use a CD ladder to reduce the effects of inflation. Three years of expenses seems like an awfully large amount to keep in cash and it might make sense if I was drawing down on my investments but I intend to live on the passive income and not sell assets. Even in a bear market or a significant down turn, not all stocks stop paying dividends and to plan that they all will is ludicrous.

To get a better handle on this I analyzed the S&P 500 dividend payout for the last 100 years and some interesting points were quick to materialize:

  • In the last 50 years the annual YoY dividend payout declined in 21 out of 50 years
  • In the last 100 years the annual YoY dividend payout declined in 35 out of 100 years
  • In the last 100 years the annual YoY dividend payout declined 10% or greater in 7 out of 100 years
  • The average annual YoY dividend payout decline was only -7.6%
  • Not once did the S&P ever payout $0 in annual dividends
  • The worst year for a dividend decline was 1938 at -34.28%

Another way to look at this is through the recent 2008 market crash and to analyze what would have happened to someone retiring at the start of 2007:

2007 2008 2009 2010 2011 2012 2013
S&P Div Payout $33.33 $34.09 $26.19 $26.18 $29.56 $34.36 $37.90
YoY % change 2.28% -23.17% -0.04% 12.91% 16.24% 10.30%

Source: http://www.multpl.com/s-p-500-dividend/table

At the start of 2007 our new retiree assumed they were all set as their dividend income met all expenses, until the end of 2008 when the market began its historical crash.

By 2009 our poor retiree’s holdings started to reduce or eliminate their dividend payouts and luckily the portfolio was well diversified across sectors and his income decline was in line with the S&P at -23%, unlike some poor souls who were too heavy into financials and had their income drop by 50% or more. Even with a diversified portfolio a 23% annual income loss is tough and it would take 4 years before income levels would recover to 2008 levels. To reduce the risk in this scenario our retiree would have benefited from having an emergency fund of cash on hand to fill the gap until income returned in 2013.

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If we add up the annual expense gaps for our sample retiree from 2009 thru 2012 it comes to a total of -60%. So logic would dictate the retiree would have benefited by keeping an additional 60% of expenses in an emergency fund to keep their income stable. 60% is a lot different than the 3 years recommended in many financial articles.

Our sample retiree sets a nice upper limit for my cash goals but for my own planning I am targeting to have passive income that exceeds my expenses by 10%. Factoring in the excess passive income and placing myself in the 2008 scenario I would have had an income gap for all 4 years of -33% of expenses. This now gives me an emergency cash target with a minimum of 33% expenses to a maximum of 60% expenses.

Analyzing the history of the S&P payout history since 1938 shows that significant multi-year declines occur every 25-30 years which places the next one in the late 2030’s and 10 years into my financial independence. With a high probability of another major event occurring I will definitely need an emergency fund. Considering I use a CD ladder, inflation will still erode some of the value as the typical short term CD is 1% below the rate of inflation. Over a 10 year period inflation would increase my minimum gap from 33% to 38% of expenses. With a 38% target defined I can now set up an emergency CD cash ladder for a 4 year period:

  • 6 month CD - 7% of expenses
  • 12 month CD – 7% of expenses
  • 18 month CD – 8% of expenses
  • 24 month CD – 8% of expenses
  • 36 month CD – 5% of expenses
  • 48 month CD – 3% of expenses

The challenge to funding this while trying to invest is the easy part. 1 year prior to retiring I will stop all auto-investing of all dividends and then roll 6 months of dividends into the CD ladder and 6 months into my checking account. Looks like I’ll have to update my retirement goals to include this CD ladder :)

Have you thought about a cash investment strategy as part of your financial independence plan?

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