In October I started the transition to drawing out of my pension funds. I am only taking the minimums to avoid taxation this financial year (to March 2020) and then plan to either do a draw-down event as a lump, or if some of my investments have not got to their expected points a smaller lump event… the markets have been slower than I though meaning I need to adapt and change what I was going to do and when.
One of the perennial questions around taking funds and setting it all up so it just ‘runs’ and does not require constant monthly actions is how much to keep as ready cash or highly liquid holdings.
They all centre on a basic theme: a flow down of returns or cash into a bucket that we draw from. Basic theory is that if there is a downturn or blip we draw out the cash/liquid stuff first, then dissolve (depending on what seems best) other mid or long term investments. Normal service resumed when at some undefined time the market recovers.
Over the past year or so I have read a number of articles from some great and very knowledgeable contributors who have argued the case for holding from zero to a couple of years worth of liquid funds.
At the zero end is the formidable EarlyRetirementNow who has a considerable economics and banking background. Some very interesting articles that make very clear points that the opportunity cost (ie the returns lost) by holding non-working funds, far outstrips the short loss if you need to sell quickly at some point. It is not hard to see the reasoning of this with a few simple calculations:
Say £30K holding at essentially zero return with inflation at 2%. After 5 years is worth a little over £27K in real terms. Contrast with £30K put into say mixed funds accumulating at say 3.8% pa and that £30K is worth in real terms almost £33K. Essentially the investments would have to loose more than 21% to put you in a worse place. It get more if the correction is say 8 years out with a correction of 35% to loose out.
ERN did a very useful and clear diagram to show this graphically (full article here) that draws on the efficient markets approach. (No links but just look up ‘efficient markets’ or ‘efficiency frontier’ – there is tons of published papers on portfolio efficiency)
It is just obvious that the leverage effect of keeping money invested far outweighs the potential loss on correction (over time)
What this really shows in a simple sense is that a small amount of cash put to work can generate a much bigger return than the possibility of small loss. It is compounding at work – the leverage effect of holding a re-investing.
I read an article from Fritz at The Retirement Manifest on Bucket Strategy about a year ago that started me considering what I needed to do. He also made an interesting observation when looking at volatility and was struck by the observation that a one day drop of over 3% in the markets he was invested in was the same as one years withdrawal. When put like that, suddenly, wow, why don’t we need a large reserve I did wonder. Then when I read various others who range up from 3 months to 18 and even 24 months and beyond I started thinking even more that a large lump might be needed. But the more I thought about it, the more I wondered whether keeping more than 100K doing practically nothing for that once in a decade event did seem excessive and simply took caution to an extreme.
The far end really have in mind sequence of returns issues. Their reasoning is that most downturns (even the 30-40% corrections) last 18 months to 2 years and generally recover to their start point within a couple of years. (It is a generalisation, but just looking at the market graphs over the past 100 years says it is a decent working assumption). So the theory is to use cash alone and maybe some yield and allow the funds to largely recover.
All have merits depending on our views and critically our comfort levels.
Perhaps this is the real point – its about our psychology and perception of risk as much as it is about numbers.
Really, if we think about it, we set up our payment scheme and run with it. If we have done our homework, done our budgets, and don’t assume its all a free for all piggy bank, then whatever draw-down system used is going to work (at least on a year to year basis). The issue is a sudden unexpected bill or payment needed that we did not plan for.
This leads to two questions:
- How Much do we need ?
- How Much Notice do we need to pay ?
In other words, what might be our view of a sudden need and critically, how much time to we get to pay. For example, if my car’s engine blew up and I needed to get a new one, we are talking a few grand (at least). But I can put that on my credit card and pay next month fully. I would get 6-7 weeks to arrange payment. If I really want I can extend that out by paying a penalty (interest at an annualised rate of 29.9%). What if my expensive cooker blew and needed to be replaced … similar. What about a sudden medical bill if I chose to go private for (UK has a free NHS with a wait), a few grand at least. How about my car catches fire and I need a new one. Interesting one as a ‘new’ car could easily be 30K (lots of insurance phaff though), but I could buy a runabout for a couple of grand and just use it 3 months while I sort finance for the wheels to last 3-4 years.
I have racked my memory to look back over the past 20 years to see when I suddenly needed a large lump of money. I certainly needed lumps at times (mostly as then I was not planning ahead and not budgeting, just reacting). They were not massive, and I had choices about funding them from either a loan or just managing the cash flow for a few months. Certainly after my divorce, company I worked for going bust and the financial crisis of 2008, long costly commute to a new job, I really had several years of living month to month. It was only when I started my own company and started systematically planning for the inevitable contract and client changes that I started looking at asset building and holding a reserve. But again, I put the money into some investments I could get at: some banks and some crowd funding. In a very real sense, I did what ERN advises – put the cash to work, hold only a tiny amount back.
So when I really think about it, aside from a small sum, I don’t need an emergency fund at all. I had no choice then. I have one now.
Is it really just psychology giving me the illusion I must make a choice ?
What about looking another way with the portfolio of investments. Some are pure growth but many pay a yield in one form or another. Some self accumulate and some pay a dividend or bond interest. There is a spread through the year and they get lumped periodically into other investments to diversity or (not happened yet mind) used for a quick punt ‘on a sure thing’ ha ha.
In one sense yield and dividend payments could become our emergency fund. After all, not all we will want to auto-invest. It is common to hold and accumulate payments to allow investment in other securities as part of diversification or simply opportunity.
Just as an example, if I had a suite of funds valued at £500K with an average yield of say 2.5% that generates £12.5K over a year. Assuming a spread quarterly, there would hardly be a time when £4-8K would not be floating and waiting for investment. If I just add in the pensions and payments we already receive and take out only necessary funding, then doing nothing at all leaves us with cash flow for at least 4 months. In 3-4 months we can all arrange additional longer term funding if we need it. Just to example that if I sum all my current outgoings and guaranteed incomes I need £11,232 income to balance to books (less if I leave out some discretionary spending). Using the dividend example in 4 months I get £6,250, so my net requirement becomes just under £5K … in a 4 months window.
So why I wonder did I think I need £20-30k as a reserve … let alone £100K ? (Some not very bright spark wrote an article without actually thinking the numbers through I wonder !!)
A year ago, I did a crude bucket model after reading Fritz’s article starting with a decent lump of cash being fed by the other buckets of investments. I modelled some wildly varying returns and corrections and rebalancing. All it really did was demonstrate to me that I don’t need a big bucket of cash, but rather a lump of 6-10K to give head room and some flex (for example a sudden holiday). But at the time I never really thought about it much. I was just playing with ideas and accumulating some broader knowledge and understanding.
My thoughts on cash now are really about physiology and comfort.
- How much confidence to we really have in ourselves and our setup/plan ?
- How much do we just need time to calm, take out the emotion, take a few deep breaths and then think about paying for a sudden big lump ?
The argument to have 6 months spending in reserve ignores fixed income streams. I would need circa £22K for 6 months but if I deduct my guarantees I need circa £17K. If I deduct the basic yield (using just a £500K example) I need between £7.5 and £11K (timing dependent). This very closely resembles the modelling I did earlier in the year.
Currently, I have about £7K sitting in my bank. The only difference I think I should do is move it to an instant access savings account that pay s at least a few quid interest.
So I just created a very crude working model that maintained a max (ish) of £7K in reserve, fed in the known guaranteed income streams, allowed for inflation in outputs and my expected SIPP withdrawal and get a variance of reserve running between about 4.5 and 7K
If I apply some variance to the dividend stream and flex my drawdown, I can see crudely when this approach stops working (or at least has the risk to do so)
Low income from SIPP – shows how vulnerable it all is but crucially shows how much time I would have to react also … months !
But if I take an income stream that generates a regular surplus allowing a transfer of tax paid income into tax free savings, I never see a problem.
- it is when there is not a regular surplus that I can feed into wider saving (tax free I might add) that I get a vulnerability to running a modest reserve
- who would have thought it, if you regularly have a small surplus, the odds of running out of ready cash are very low … only obvious when you think about it and run the numbers.
In pretty much any scenario, I could miss taking a SIPP payment for a couple of months without impact, I could suddenly not get dividends for 6 months…. I get time … 3-4 months before I have to do something…. surely the point !
Whilst I respect the many writers who have discussed and made argument for holding 6,9, 18 month+ liquid assets, I do think, this is all about a personal comfort blanket. In pretty well every scenario I can think of, any really immediate lump needed I can plan for payment over a couple of months and that gives me loads of time to arrange any alternate funding.
I don’t really buy the sequencing argument that we must leave funds alone to recover. Like many, there will be a wide portfolio worldwide based with a mix of asset types – they will not all ‘crash’.
That £7K I hold still represents knocking on 15% of what I expect to spend in a year (more than 20% of what I have to spend, ie knocking out some of the discretionary spend like holidays ) – and this does not include the guaranteed income streams (not huge, but guaranteed and index linked). I can see the maths that says holding 3K would be more than adequate, but I just don’t want the phaff.Some years ago I went to an aviation safety meeting (I do a little flying now and again) to see a big cartoon of a plane with an over-large in perspective person pouring petrol into the wing tank to the brim with the meme ‘That’s Time in your Tank’ . Using that analogy, a little extra headroom is ‘Time to Plan, not React’. With the realistic model showing a variance from around £4K-7K depending on the dividend streams I have it.
- So the need to have a specific fund must really come if we have a high risk or expectation of a high value sudden need. Otherwise, we should be able to plan our way out without too much trouble…. surely.
So for me, a buffer of between £5K and £7K represents a cushion of 10-15% which is plenty.
We like Rules of Thumb. They distil knowledge and understanding into simple and easy to apply statements. So what about a rule of thumb ? Could I really say with some confidence one ? Well yes .. I do think so now I have run a few numbers ….
Holding a range between 10-15% of your planned annual spend will give enough of a buffer to varying and variable income streams as long as a regular (however small) monthly surplus is generated.
Whatever way we look at it, a Cash Bucket is really made of two parts: a small buffer; and, however big we choose to make it, a comfort blanket ! – Don’t let anyone fool you into thinking you need a year or more of cash lying around.