With savings accounts and certificates of deposit continuing to
pay next to nothing, you may fret that you'll throttle your nest
egg if you follow the widespread advice to maintain a cash reserve
of up to a year for expenses. No worries: A new study shows that
your nest egg may actually last longer if you keep a one-year cache
Researchers found that both taxable and tax-deferred accounts
with cash reserves generally have better survival rates over a
30-year retirement than accounts without a cash allocation.
Portfolios that include cash are better able to withstand the
impact of taxes, transaction costs and volatility, the researchers
Many financial advisers have long recommended cash reserves as
insurance against investors having to sell investments in down
markets to cover expenses. Others, however, counter that large cash
reserves earning close to 1% or less crimp a portfolio's
performance. The latest study shows that when the costs of taxes
and trading are taken into account, having a cash stockpile can
more than offset the higher returns produced by investing the cash
in other assets.
The researchers compared two $200,000 retirement nest eggs. One
had an allocation of 60% stocks and 40% bonds. The other nest egg
had two buckets. Four percent of the portfolio was allocated to
cash, enough, at a rule-of-thumb inflation-adjusted 4% withdrawal
rate, to pay for expenses for a year. (Presumably, the retiree had
to supplement the $8,000 expenses reserve with Social Security,
pension payouts, rental income or a part-time job.) The other
bucket was allocated to stocks and bonds at slightly lower
percentages than the first nest egg. In one scenario, the retirees'
assets were in taxable accounts, while in another they were in
tax-deferred accounts, such as an IRA or a 401(k).
Assuming an inflation-adjusted 4% withdrawal rate, the
tax-deferred account without a cash reserve had a 55% chance of
surviving 30 years, compared with 59.4% for the tax-deferred
account with the cash reserve. The non-cash nest egg incurred a
median $21,600 in transaction costs over 30 years, compared with a
significantly smaller $2,520 for the nest egg with the cash
Cash was king as well when both nest eggs were in taxable
brokerage accounts. The survival rate for the account with the cash
reserve was 66%, compared with 60% for the account without the cash
bucket. The transaction costs were similar to those in the
The accounts without the cash reserve had considerable trading
costs because the investment portfolios needed to be tapped every
month for expenses, says study co-author John Salter, associate
professor of personal financial planning at Texas Tech University.
Each trade was assumed to cost $30, far more than fees charged by
discount brokers but less than typically charged by full-service
brokers. The study assumed two trades each month.
Slashing Transaction Costs
Meanwhile, stocks and bonds in the accounts with the cash cache
were tapped once a year when the reserve needed to be replenished.
"Instead of transaction costs 12 times a year, we're incurring
those costs only once," says Salter, who also is a certified
financial planner at Evensky & Katz Wealth Management, in
Lubbock, Tex. Co-authors were Harold Evensky, president of the
firm, and Shaun Pfeiffer, associate professor of finance at
Edinboro University, in Edinboro, Pa.
For the taxable accounts, the median tax bite over 30 years was
slightly higher for the nest egg without the cash reserve--$73,993
compared with $71,886. All the trades were assumed to incur 15%
long-term capital gains. One reason for the higher tax tab: More
income comes from the stocks and bonds than from the cash. In an
actual portfolio, accounts without the cash reserves would likely
rack up more taxes because some of the monthly trades would throw
off short-term capital gains, which are taxed at ordinary income
tax rates of up to 43.4%, Salter says.
Salter says that for many years, his firm set up two-year cash
reserves for clients. The more cash, the lower the transaction
costs--but "there is also an opportunity cost of more cash not
being invested," he says. In today's markets, he says, "one year
ended up being the optimal solution to the tug of war."