How much cash in a retirement portfolio?

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An reader asks:

I’m researching how much cash to set aside (likely in a money market and CDs) to weather any market downturns. I’ve seen everything from six years to two years. I’m considering 3-4 years for enough to weather almost any large downturn but also to not keep too much of my portfolio in cash. I noticed from your profile that you keep just two years. I’d like to know your rationale, if you’re willing to share it.


My spouse and I have developed a pretty straightforward rationale: most bear markets last for less than two years, and we hope they continue to do that!

Part of this plan is supported by our annuity: my military pension. No matter how bad the markets get, or how low our investments go, every month we have enough income to buy groceries. However, a military retirement is just one type of annuity income for longevity insurance. All retirees, military and civilian, should have either a pension or an annuity for a portion of their income– and it probably needs to be more than just Social Security.

Another part of financial independence is a diversified asset allocation. Part our portfolio is invested in the iShares Dow Jones Select Dividend Index Fund. Again, even in a bear market, that ETF will pay its quarterly income. (The amount of the dividend dropped by about 10% during the Great Recession and quickly recovered.) It’s more risky than most pensions (and annuities), but it could be expected to keep up with inflation.  Unfortunately we don’t own enough shares to supply all of our cash needs.

However, my pension and our dividend income won’t cover all of our expenses, so we keep about 8% of our portfolio in cash: enough to last for two years.

We start out each year with that cash stash fully funded. At the end of the year, if the market is flat or up, then we sell some of the rest of our portfolio’s assets to replenish the stash for the next two years. We’re using a 4% withdrawal rate on our portfolio, so it’s likely that every year we’ll spend some of the principal.

If the market has gone down, though, then we don’t replenish our cash allocation. We continue to spend the rest of the cash stash during the second year. By the end of that second year we’ll have to either sell more of the rest of our portfolio’s assets or we’ll have to cut back our expenses. (That’s what we mean by hoping that a bear market will last for less than two years.) We’re also hoping that the markets are recovering, too, because at the end of that second year we’d be selling twice as much to replenish the cash allocation back to 8%.

If a recession lasts for longer than two years then the worst case would be cutting our budget– and selling whatever assets lost the least while attempting to stay within our asset allocation. But we’ve owned some of our equity shares for over a decade, so we should still have unrealized capital gains.

Many investors are unhappy with today’s low-interest rates on savings, money markets, and CDs. When you’re keeping a portion of a portfolio in cash, it’s tempting to chase yield by putting that cash in riskier assets like junk bonds or high-yield stocks. However, we’re already taking enough risk in the rest of our portfolio because we expect to be able to leave it alone for at least two years. We don’t take any risk of losing principal with our cash allocation because we’ll be spending that money– it’s a critical part of our overall portfolio’s diversification.

Instead we’ve been chasing yield (a bit) by building a longer-term CD ladder out of our cash stash.

The theory is that a bear market only happens once or twice a decade, so there’s not much risk of breaking into a long-term CD. We put the first year of our spending cash in a money market savings account, and the second year of our spending cash is laddered in three-year CDs. (The CDs have an early redemption penalty of six months’ interest.) If the market has a flat/up year then we replenish the money market directly from selling other assets in our portfolio (and we renew the CDs). If the market has a down year then we have a CD maturing during that second year, and we might have to break into one or two others before they mature.

The cash stash also has to be big enough to let you sleep at night. For us, two years’ expenses is a sweet spot based on having a military pension (with a COLA). If we had less annuitized income then we’d keep a bigger cash stash, too, or be ready to make severe spending cuts. For your own personal situation and asset allocation, 3-4 years may be enough of a stash to ensure that you sleep comfortably at night too.

Note that this system means that we’re rarely, if ever, buying more equities. In flat/up markets we’re selling to rebalance and replenish our cash for the coming two years.


Related articles:
Details of the 4% Safe Withdrawal Rate
Is the 4% withdrawal rate really safe?
How much will military veterans leave on the table?
Questions on the 4% “safe” withdrawal rate
Chasing yield
Military retirement: how much can I really spend?
Retirement finances: what will I spend?
Darrow Kirkpatrick of “Can I Retire Yet?” on dipping into principal


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WHAT I DO: I help you reach financial independence. For free. I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers, veterans, and families. All of my writing revenue is donated to military-friendly charities.

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