Howard Gold's regular commentary won't appear today, and we are reprinting this column instead.
The great crash and bear market we’ve lived through has shattered many market myths. But one that seems to have survived is that investors shouldn’t hold too much cash, even if they’re close to retirement, because its value will be eaten away by inflation over time.
The only way you can be sure you won’t outlive your money is by keeping a big chunk of it in stocks, the conventional wisdom goes. That “wisdom” prompted far too many retirees to put 60% or 70% of their retirement savings in equities. When the market tanked, it was like lambs being led to the slaughter.
But some new research suggests that boring old cash—money market funds, certificates of deposit, and short-term government bonds—actually can beat inflation most of the time. And I’ve found that investors can hold as much as 40% of their assets in cash during retirement and still not outlive their money.
In other words, cash isn’t trash.
Ibbotson Associates, now a Morningstar company, has tracked returns of different asset classes for years. Its data show that cash earned 3.7% a year from 1926 through the end of 2008. The annual inflation rate was 3% during that time, so cash stayed ahead of inflation over those eight decades.
And Michele Gambera, Ibbotson’s chief economist, says that since 1973, cash has stayed ahead of inflation in almost all periods (see chart). The exceptions: during the out-of-control inflation of the mid-1970s and Alan Greenspan’s ultra-low interest rates earlier this decade.
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“Three-quarters of the time it was above the inflation rate since 1973,” he told me.
“When inflation is expected, it’s not a problem. Everything is priced in,” he explains. The market is incredibly sensitive to inflation, so rates on cash instruments will move up in anticipation of rising prices (especially if the Federal Reserve is hiking rates, too).
For decades, enterprising retirees and others have shopped around for the best returns on CDs and money market funds. A glance at Web sites like Bankrate.com shows how competitive this market is as banks and other financial institutions pay rates above inflation to lure customers.
And although cash would have given you only $9 in 2008 (after inflation) for every $1 you invested versus $99 for government bonds and $9,549 for small stocks, according to Ibbotson, those returns are calculated over 80 years.
In periods like now, essentially a long-term bear market since 2000, stocks have produced zero or even profoundly negative returns for years, and we don’t know how long this will last.
Investors who poured in money at the top of one of the bubbles we’ve seen this past decade may never recoup what they’ve lost. It has been catastrophic for too many Baby Boomers who will retire over the next decade and learned first hand that big stock returns can vanish in the ether, while cold, hard cash sits in the bank earning interest.
That’s why Gambera urges investors who have, say, less than $250,000 and need to live off their savings to keep their money in cash. (At a 4% withdrawal rate, that’s at most $10,000 a year.)
“If a person doesn’t have a lot of money, they shouldn’t take any risk, because they can’t afford to,” he says.
I wouldn’t go that far: I think most people should have a decent chunk of their portfolios in stock. But some number crunching I did convinced me people can own a lot less stock and hold a lot more cash than many financial planners recommend.
Using the Retirement Income Calculator at troweprice.com, I tried to find out how much cash a fictional near-retiree named Joe Josephson of Denver, Colorado could hold and still not run out of money in retirement.
Joe is in his mid- to late fifties, earns $80,000 a year and has $500,000 saved for retirement. (That’s a lot bigger than the median Baby Boomer, but a reasonable amount after a lifetime of saving and investing.)
I also assumed he will retire at age 66 to get full Social Security benefits and will continue to save 20% of his income ($16,000) a year until he retires. Retirement living expenses amount to $5,000 a month, three-quarters of his pre-retirement income. To keep things simple, we didn’t include a pension or a spouse’s income or Social Security benefits.
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For Mr. Josephson, even a conservative preretirement portfolio of 40% stocks, 30% bonds, and 30% stocks and a retirement mix that includes 40% cash would give him at least an 80% chance his money will last until he turns 90. By tweaking the retirement portfolio just a bit (to a one-third stocks, bonds, and cash mix) and working an extra year, he should be OK until he’s 95.
In fact, after trying many different scenarios, I found the exact mix of stocks, bonds, and cash wasn’t critical in determining whether Joe would outlive his money. What mattered most was how long he stayed in the workforce and how much he saved during that time. Oh, yes, and earning a little money in retirement helps a lot.
The moral of this little exercise? You don’t need to take on too much risk to achieve financial security in retirement. In fact, cash and bonds are the underrated asset classes, which saved many a portfolio in last year’s market disaster and the previous “lost decade” for stocks.
“Cash and high-grade bonds are the true diversifiers,” says Richard E. Band, editor of Profitable Investing, an independent advisory service. He recommends people set aside enough to cover their first three to five years’ living expenses in retirement in cash or short-term bonds. That would be at least $180,000 in Joe Josephson’s case—almost 40% of his retirement assets.
Like Gambera, I also think you should have a nice chunk of your bond holdings in Treasury Inflation Protected Securities (TIPs) to protect you from those “bursts of inflation” when cash lags, as he puts it.
This kind of advice won’t make brokers rich, and it won’t make financial advisors comfortable: They’re still stuck in the mindset that you need a huge stock position to protect your wealth over time. That, of course, was a very, very bad idea for too many investors in 2007 and 2008.
So, if you’re still licking your wounds (and who isn’t?), don’t let someone talk you into taking much more risk than you’re comfortable with. Sometimes cash is indeed king.
Howard R. Gold is executive editor of MoneyShow.com. The opinions in this column are his own.
