- Following the 4% rule is not enough when accumulating wealth.
- The recent market decline brought on by the pandemic requires around a third more index fund shares to be sold to maintain spending patterns if you are in retirement and are fully invested at all times.
- How much money you should keep in cash depends on where you are in the wealth building cycle. How close you are to retirement, or if you are in retirement, determines the appropriate level of cash that should be held.
- The 4% rule fails too often if not coupled with appropriate cash levels.
Rules of thumb are an easy way to quickly see where you stand financially. Once you reach 25X your spending in liquid net worth (the 4% rule presented as a multiple of spending) you are assumed to have enough to retire under the 4% rule, regardless your age.
However, as we are seeing with the current market turmoil, the simple rule of thumb has one fatal flaw. If you reached your 25X goal a few months ago and decided this was the time to step away from traditional labor, you now face a withdrawal rate from your index funds a third higher than expected. This will reduce the account value early in the distribution phase, lowering the total amount you can get from the investment over your lifetime.
Another rule of thumb is to keep 6 months of spending in cash in case you become unemployed. Under a normal job loss or economic decline this would be a reasonable policy to follow. Unemployment insurance can provide additional cushion to the 6-month cash reserve.
Black Swan events (unexpected negative economic events such as the housing crisis or pandemic) throw the whole rule of thumb out the window. Black Swan events do not happen often, but they do occur every decade or so. Looking back at U.S. history, it seems something always happens every decade to knock the markets lower and slow economic activity. The 2010s are the only decade to avoid that fate and 2020 seems to be making up for the oversight.
Black Swan events are impossible to plan for, but you can manage your investments with the understanding something unknown will shake the market’s confidence every so often. You can prepare contingencies to deal with unexpected market breaks, or take your chances and hope you get lucky… this time.
Determining Your Proper Cash Level
One of the hottest topics of discussion in consulting sessions with clients involves how much liquid net worth be held in cash. Emails and even social media requests from followers press on how much cash is the right amount of cash to keep on hand as a percent of investable money.
The 4% rule doesn’t consider a cash position. It just assumes you take 4% every year from your portfolio to live. If the market declines, the 4% rule says you either need to cut back on spending or risk running out of money before death. Cutting spending enough isn’t always possible. And when markets are down many goods and services become cheaper so you should be stocking up at these times. The 6-months cash rule also falls short in many cases. A down market can last for years and selling at a low to fund living expenses is a painful exercise.
Where you are on your journey to retirement determines the amount of cash you keep on hand. Many times readers of this blog, and those who follow me on social media, think I am timing the market when I carry a substantial cash position. But that isn’t true. I have no desire, nor skill, at timing the market and do not waste any time trying to do so. I do, however, increase my cash position when the sun is shining and decrease my cash position when it rains. This isn’t a timing issue. As I near retirement and have substantial financial resources, I have no desire to maximize my returns. I already made it. No room for heroes anymore.
You are probably at a different part of the wealth creation cycle. Maybe you are older and well into retirement, collecting a pension and Social Security. Or just starting out.
The advice I give clients is based on their specific facts and circumstances. I will give you the same advice here based on where you are on your journey to retirement, early or otherwise. I will finish with my advice to clients already in retirement. You can use these guidelines to prepare for your retirement. Knowing the appropriate way to invest at each stage of the wealth creation cycle is helpful; looking to the next step in advance can be very motivating, knowing you will have plenty of financial resources once you do retire.
Before we start I need to define some terminology. When I say cash I mean money market accounts, bank deposits and CDs. Everything else is invested, meaning broad-based index funds, most notably Vanguard’s S&P 500 Index Fund (VFINX or VOO for the ETF) or the Vanguard Total Stock Market Fund (VTSAX).
Starting Out: When you start out you have the fewest resources. Time is your best friend, however. The sooner you get money invested the sooner it can start growing. And time invested determines your level of wealth. Cash reduces the level of wealth years down the road, but keeps an unexpected expense from turning into a disaster that sends you back to square one. It is a delicate balancing act between investments and cash.
The problem with too low a level of cash is twofold. First, any minor emergency (flat tire, furnace repair, medical bill) and your financial plan is in crisis. Second, job loss or disability can destroy all the work done to-date.
Starting out is the riskiest place financially. By default you will be closer to the red line; income and savings are generally lowest when you are young and starting out. Six months of spending in cash is probably impossible. And if your employer matches contributions to your retirement account you need to find a way to contribute at least to the matching level.
If you are at day 1 you want to take a page from Dave Ramsey’s book (and workbook). His Baby Step #1 is to get $1,000 into a bank account for emergencies. It’s a good plan I agree with. If you have an employer retirement plan with matching, try to invest at least to the matching level as well. A good way to start is by adding $50 every paycheck or per month to your emergency fund until it reaches $1,000. When an unexpected bill shows up you have the funds to deal with the issue. Then start adding $50 or so each pay period to restore the emergency fund to at least $1,000.
The balancing act would be reasonable if all you had to worry about is building a reserve while you are earning starting wages. Add to that the expenses of starting out (furniture, transportation, home furnishings), a mortgage or rent and it can quickly become overwhelming.
There is one advantage you have when starting out; you are young. With youth comes resilience. Starting a family, paying down a mortgage, building a retirement fund while working many hours to achieve these goals takes the vigor of youth. It can also wear you down.
Regardless your level of energy, financial problems can wear you out. That is why even a modest emergency fund, Dave Ramsey style, can be such a powerful tool to keep you on track. The real risk is job loss, medical issues and disability before you build your finances to a level where you can withstand larger financial assaults.
That leads us to the next level.
Building Wealth: You will spend more time at this level than the starting out phase. A $1,000 emergency fund really isn’t enough, especially as you grow older and medical bills have a greater chance of messing up your plans. Job loss is a strong possibility at least once in your working career. The 6-months of living expenses rule now comes into play. The truth is, 6 months still isn’t adequate. An extended economic decline can put you into a bad position where you are tempted to add more debt or tap into a retirement fund to pay for day-to-day expenses.
In the wealth building phase you want to secure your finances to withstand as much as possible. Many people don’t keep an official emergency fund once they build a modest net worth. (This accountant never had any funds earmarked for unexpected expenses.) However, that doesn’t mean you don’t have a tidy stash of money tucked away to get you through an income drought.
These are the priorities in the wealth building phase:
- Pay down and eliminate debt
- Build a cash reserve for surprise expenses and to tide you through a reduction in income
- Grow your retirement savings
- Invest outside your retirement account (non-qualified accounts)
There is no fast way to accomplish these goals, but there is an easy way. Consistency wins the race. Paying a bit extra each mortgage payment will eliminate the mortgage years early; every paycheck should add to your retirement fund in good or bad stock markets automatically; merge your emergency fund into your other non-qualified investments and make investments automatic.
I use Vanguard. You can use Vanguard or any similar investment house. Retirement and non-qualified investments will grow as the years peal away. The tax advantages of retirement plans are the best deal in America for the middle class. Adding to your retirement funds with each paycheck is about the easiest and most painless way to dollar-cost-average there is.
Once you fill your retirement account it is time to build some non-retirement funds. Non-qualified investments can be an appropriate surrogate for an emergency fund. A modest $1,000 worked when you were starting out. As you build your wealth $1,000 is inadequate; you are no longer interested in borrowing money to buy a car or anything else for that matter. You need larger sums of liquid money to replace a car or repair a roof. Investing in a broad-based index fund is the perfect way to grow your non-qualified monies.
This is where common sense comes in. As you grow your non-qualified account some money will be held in a money-market fund or bank deposit. When a planned, budgeted or surprise bill shows up you will have the resources to pay the expense immediately. To reach this financial position you need to add consistently, just like with your retirement account. You can make the investment automatic in your non-qualified account, the same as with your retirement account. Set up automatic investing with monthly contributions. Part of each payment should go into the index fund and some into the cash portion of the account. When the stock market is acting like the world is about to end again, put most of the new money into the index fund. If you are uncomfortable with the high level of the stock market, put most (not all) of the new money into the cash account. It isn’t a crime to have a lot of cash! Sleeping well is better.
If the economy sours you can always move cash into the index fund. Once you determine your income is not at risk and will remain steady or climb, you can lower the cash position. This is more art than science. There is no exact level of cash you must have. Rather, if you feel uncomfortable, there is nothing wrong with sitting on the sidelines. In fact, the more wealth you have the less likely you want to be 100% in equities all the time. Cash is always nice because it gives you the opportunity to invest when the right investment comes along. It is hard to buy a cheap income property if you can swing the purchase. And cash is always available for spending needs without worry about selling in a bear market.
My point is that you decide what is best for you. Almost everyone should have at least some portion of their portfolio in equities in the wealth building phase. The first goal should be to increase your liquid funds to around 6 months of expenses. This should provide an adequate cushion if things go south. Then get serious about growing investment accounts.
The greater your wealth the better able you are to weather a storm. As your non-qualified account grows, the 6 months of living expenses in cash are supplemented by dividends if the need become great enough. Dividends and capital gains should be reinvested into your index funds. However, rather than selling an investment when the market is down, consider diverting dividends and capital gains distributions into your cash account when the cash account begins to deplete. This will provide added cushion while you decide the best financial move if a recession hits the family income stream.
Nearing, Entering and in Retirement: The last phase of your financial life is when you approach, enter and are in retirement. The following advice works regardless the age you retire. Early retirement still requires a proper financial plan. My clients pay me a lot of money to tell them what you are about to read.
The 6-month rule is nowhere near acceptable once you enter retirement. Side hustle income, pension and Social Security keep cash flowing into the budget, but your maximum earning years are now part of history. And besides, even if you can go back to work, is that really the goal here? The goal now is to structure your finances to keep your financial life simple with as low a level of risk as possible.
There might be times when you still add to investments once you enter retirement. We will assume retirement is a consumption of wealth phase. This doesn’t mean your accounts lose value! Your level of consumption can, and ideally should, be lower than the rate of the investment growth.
Outside cash, investments will fluctuate in value. Only the fluctuating investments provide a potential acceptable return. Cash provides a low, or even no, return and is earmarked for expenditures in the relatively near future. Selling index funds at or near market highs and consuming cash when index funds are not at a high is an easier strategy than you might think.
Market timing is a sucker’s game. Dollar-cost-averaging when you were growing your wealth was not a market-timing call. The opposite behavior when consuming your wealth is also not market timing.
The stock market is always climbing with short down periods lasting from a few months, to a few years, to rarely a decade or longer. Selling at a market high does not mean the market will not be higher in the future. What I am saying is that selling at or near a current market high is easy to do. Look at the index level. Is it at or near a high? Then it is an appropriate time to sell if it meets the criteria discussed below.
Your cash position in retirement needs to be at least two years of spending! Preferably 3-4 years of spending. With 4 years of spending in your cash account you have plenty of money available to live without consideration for the economy or stock market levels. If the market declines, use the cash account to fund spending. If the market is at or near a high you can sell enough to cover your needs on a monthly or some other schedule. You can rebuild the cash position when the market returns to new highs if the cash account becomes depleted.
When the stock market has one of those wonderful moments where it predicts yet another zombie apocalypse, you have several options. Rather than reinvesting dividends and capital gains distributions, you can divert those to your cash account instead. This effectively stretches your cash account to cover more than 4 years of market decline. Only as a last resort would you be forced to sell below a market high and/or cut back on spending.
The stock market rarely goes down and stays down for more than 4 years. Anything is possible. With dividends mixed in, your cash position can extend to 6-7 years or more, depending on the amount of your investments in index funds. Virtually all situations become background noise then as you enjoy your retirement.
As you can see, a simple rule that works for everyone does not exist. When you are starting out it is unlikely you have the resources to have even 6 months of liquid cash available to cover a job loss or serious expense. The goal is to move from that risky early position to a more stable and secure level. Eventually you will reach that 6-months cushion. But then you need to keep pushing because your needs will change as you approach retirement.
The more wealth you accumulate, the more comfortable you become with cash earning a meager return. Many people lose interest in remaining 100% invested all the time once they enter the 7-digit net worth arena. As the 7 figures keep climbing, cash looks better and better. Of course, virtually everyone should have some invested in an equity index fund at all ages. What I want to impress upon you is that in the early days of your wealth accumulation journey you will be nearly 100% invested all the time with a modest sum available for an emergency. As you approach and enter retirement it is not uncommon to have 20% of more of your investable funds in cash. Find your comfort level and enjoy the well-deserved retirement you worked so hard to attain.
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