The global pandemic is causing many people to lose their jobs, or at least experience a short-term reduction in income. Government programs are stepping in to help, but only as a small safety net. The wisdom of maintaining an emergency fund of at least 3-6 month’s worth of living expenses in very safe cash equivalents has never been more apparent than now. This emergency fund is there for these times, where income may be temporarily suspended or reduced, and equity fund values are well below their highs. This is often the case during periods of economic stress where the times when you need to dip into savings coincide with bear markets.
The month of March also reminded us how low risk investments are not the same as no risk investments with many short-term fixed income ETF’s experiencing large declines of 10% or more. With regard to your emergency fund, it’s best to stick with FDIC insured high yield savings accounts and money market mutual funds and ETF’s that limit their holdings to short term government and other high-quality securities. This lowers expected returns, but the point of an emergency fund is to act more like insurance than an investment. Buying various forms of insurance also lowers returns every day you don’t file a claim, but the thought of not having insurance during an unexpected time of need is unimaginable.
For those in retirement who are living off a combination of Social Security and portfolio income, it’s wise to maintain a larger emergency fund of around 5 year’s worth of living expenses that are not covered by guaranteed income sources like Social Security. Each situation will vary, but this is a good starting point and is based on the historical analysis of how long well diversified balanced portfolios have remained in drawdowns. An example might help:
- 66 year old retired couple
- $1,000,000 in total savings
- $50,000 in annual Social Security income
- $90,000 in desired inflation adjusted total annual income
The example above highlights how there is a $40,000 annual income shortfall that will need to be covered by the $1,000,000 in retirement savings. With current yields on riskless Treasury Bills around 0.10%, it’s clear that keeping the entire nest egg in cash equivalents will not work long-term if either one of them were to live to age 100.
At the other extreme, investing the entire $1,000,000 balance in a diversified equity portfolio and withdrawing $40,000 per year from a combination of dividends and selling shares would work well in most historical periods, but carries uncomfortable volatility and the risk of irrecoverable losses if the first several years include a large decline with more of an “L shaped” recovery than we’ve seen historically. Money spent cannot recover. So a balanced approach is sensible, for example:
$40,000 per year * 7 years = $280,000. Assume that these assets are held in a combination of cash and intermediate term US Treasury funds. The remaining balance of $720,000 is invested in a globally diversified equity portfolio. Together, this is a “72/28” balanced portfolio of stocks, bonds, and cash. With this mix of assets, an investor is ready for good markets and bad. During down years the withdrawals can be funded primarily or entirely by cash and bonds as part of the rebalancing process. During up years, rebalancing from stocks as they get overweight back into cash and bonds to maintain the 72/28 mix further increases the years of living expenses in low risk assets.
A global pandemic naturally makes us all reflect on our lives and our finances. The key, as always, is to have a well thought out plan that anticipates economic stress and equity bear markets as it’s near certainty that they will continue to occur in the future. This plan should balance risk with reward, according to your personal needs and tolerance for uncertainty. Any plan is better than no plan, as those without a plan are the ones most likely to cause irrecoverable damage to their finances when stress and fear are at their highest.
Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.