As the Fed has finally lowered rates and signals that it anticipates up to another half of a percent decline by the end of the year, both accumulators and retirees are faced with the question of what to do in a declining rate environment. For many clients, a relatively straightforward strategy for cash management for the past two years has been to put money in a high-yield savings account or some short-term CDs, often yielding north of four percent and five percent, respectively. Yet, in a declining rate environment, we will soon see savings accounts slip south of four percent and possibly even lower, and CDs that mature are likely to be renewed at much lower rates and with much shorter durations. This week, we’re discussing how to approach cash management from a simple emergency fund to a full financial independence portfolio and how such approaches can help preserve your purchasing power while avoiding undue risk.
The High Yield Savings Account
A not-infrequent critique of high-yield savings accounts is that they’re not really high-yield. In a relative sense, an account yielding something like 4% when inflation is 2.5% doesn’t pay enormous dividends, but it preserves purchasing power, which is extremely important in any emergency fund. Yet, the critics of the high-yield savings account often do so on the back of the observation that the banks offering them are usually just buying short-term US treasuries and pocking some amount of the interest before paying out the rest to you. This is a faulty comparison for a few reasons.
First, while US treasuries are often considered low risk because of their liquidity (the ability to convert them easily into cash, they can still suffer from a decent bit of marketability risk. Marketability risk is the risk of selling the asset in a hurry, which can result in having to sell at a discount to accomplish the outcome. For example, imagine you’ve bought a one-year treasury paying 4%. If the Fed lowers rates by 1%, that would probably boost the face value of the bond, making it more attractive to sell. However, if the Fed were to raise rates by 1%, then you’d likely have to sell it at a discount. The fed rate itself hasn’t changed the nature of the bond, but the marketplace will reprice the bonds for more or less than it might have cost at issue, and consequently, while the Federal government fully backs the investment, you may still find that you could lose money on the investment due to a need to convert your investment into cash sooner than the maturity of the treasury.
While banks technically face the same risk, the difference between you and them is that they typically have millions or billions in deposits from which they can draw to fund a redemption from your bank account. A bank run could occur if every depositor suddenly wanted to pull their money out and the forced liquidation of investments led them to have a shortfall in cash, but from an individual to individual circumstance, you’re not likely to find yourself unable to get a withdrawal from your bank on any occasion, whereas you could lose real money by trying to base your savings on a securitized product.
How much cash?
There are many nuances to what constitutes a necessary emergency fund, but we’d typically price that at three months of income for a married couple adjusted for differences in income or six months of income for unmarried or unpartnered individuals. When thinking about balancing three months of income for spouses with relatively equal incomes, this is fairly straightforward. Both of you earn $100,000 a year for a total of $200,000 in gross annual income? Keep $15,000 in your checking or high-yield savings and another $35,000 in high-yield savings, money market accounts, or very short-term CDs. Don’t overthink it; it’s just 25% of your annual income.
But if your incomes are quite different, say $80,000 and $200,000, then we should be approaching this with a closer eye towards your expenses and how much of your fixed necessity costs of living are paid for from the $80,000 earner versus the $200,000 earner. If that same example household has $100,000 in annual fixed costs, then an emergency fund of $25,000 might be sufficient because even if the higher-earning spouse loses their income, that $25,000 amount plus the still-employed spouse’s income can more than provide for their expenses for a full year. However, if their lifestyle costs $220,000 per year, then we need to put aside significantly more cash because the $80,000 income cannot overcome even half of the household’s needs.
Too much cash?
We occasionally encounter folks who are great savers or perhaps terrible spenders. Suffice it to say they have well over a year’s income, sometimes several years’, simply sitting in their checking and savings. In these scenarios, we have to talk about short-term goal funding and long-term financial expectations. While cash is a popular safe harbor asset due to its relative stability, the problem is that most of the time, particularly in a low interest rate environment (think 2008-2018 or 2020-2022), you are constantly losing purchasing power by holding onto cash because inflation will often exceed interest rates available in FDIC insured bank products. In those scenarios, if there’s a short-term goal that needs funding, such as a home purchase or a wedding, we may just have to pay the costs of inflation. However, in cases where the household has only long-term ambitions for their money, such as their newborn’s college fund or their retirement, then that money should be put to work in the market through a diversified portfolio or perhaps applied to increasing human capital through education or investing in direct assets such as their business or real estate.
Regardless of the strategy for managing cash, there can be such a thing as too much cash, even for retirees. Some clients deliberately maintain multi-year cash savings in retirement simply to buffer out any degree of volatility. This is a fine idea, but might be more optimally accomplished through the purchase of an annuity or the utilization of a home equity line of credit or a home equity collateralized mortgage. Your mile may vary circumstance by circumstance, but there does come a point at which even the most conservative retiree simply is holding onto too much low or negative productivity capital, and it needs to be put to work, lest they come to find they’re short on money later on in life.