Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How a Cash Reserve Protects Early Retirement From Sequence Risk
Transcript
- Lucas: I've been digging into a case study from the 2022 bear market — a couple who retired at 52 with one point two million dollars. Their plan was a classic 4 percent withdrawal, but they had one unusual feature: they kept two full years of living expenses in cash. About 80 thousand dollars, just sitting in a high-yield savings account. Luna: That sounds like a lot of cash drag during a bull market. But I imagine it paid off in 2022? Lucas: Exactly. When stocks dropped 20 percent that year, most retirees face a terrible choice: sell low to fund spending, or cut spending drastically. This couple simply spent from their cash pile. They didn't touch a single stock or bond. By late 2023, when the market had fully recovered, their portfolio was back to its pre-drawdown value — plus dividends — and they still had about half their cash reserve left. Luna: So the cash reserve essentially prevented them from locking in losses. That's a clean illustration of why sequence risk matters. Lucas: Right. Sequence risk is the danger that a bad market in the first few years of retirement permanently damages your portfolio. A cash reserve is one of the simplest ways to insulate against that. The couple's experience matches the data: research from Bill Bengen — the guy behind the 4 percent rule — showed that holding one to two years of cash can increase the success rate of a withdrawal plan by 5 to 10 percentage points. Luna: How much cash are we talking about? And where does the opportunity cost show up? Lucas: The common rule of thumb is one to two years of essential expenses. For a retiree spending 50 thousand a year, that's 50 to 100 grand. The opportunity cost is the forgone market return — roughly 6 to 8 percent annually on average. But over a 30 year retirement, the cost of that cash buffer works out to maybe 2 to 3 percent of total portfolio growth. That's a small insurance premium against having to sell during a 30 percent crash. Luna: The trick is deciding when to refill the cash bucket. Do you replenish right after a drawdown, or only during up years? Lucas: That's the key operational detail. The standard approach is to replenish the cash reserve during periods when your portfolio is above its inflation-adjusted starting value. In the case study, they waited until the market regained its previous peak, then took the cash from a rebalancing of their bond and stock allocation. That way they avoided selling stocks when they were still recovering. Luna: That makes sense. It's almost like a dynamic rebalancing rule that prioritizes preserving the cash buffer. Lucas: And it doesn't require any fancy strategy. By the way, if our money conversations have helped you think about a decision differently — maybe your own retirement plan or how you handle market downturns — we keep this show ad-free thanks to listeners who chip in a couple bucks. A few dollars a month is genuinely what keeps these going. If you've gotten something out of them, buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to support the work Lucas and I put into digging up these case studies. Totally optional, but it helps us keep the archive open for everyone. Lucas: So back to the cash reserve. One question people ask is whether you should use a high-yield savings account, a money market fund, or even short-term Treasuries. For this couple, they used a high-yield savings account yielding around 3 percent in 2022 — not great, but it beat inflation that year. Currently, short-term Treasury bills offer about 4.6 percent. The point is to keep it safe and accessible, not to maximize return. Luna: What about taxes? If you're drawing from a cash account that's outside a retirement plan, you're just paying ordinary income on the interest. But if that cash is in a traditional IRA, you'll pay income tax on the entire withdrawal. Lucas: Right. Ideally, the cash reserve sits in a taxable account so you can control the timing and the tax cost. That couple had their cash in a taxable brokerage settlement fund. The interest was minimal, and they withdrew only what they needed each month. They also harvested some capital gains in their taxable account in 2023 to refill the cash — staying within the zero percent capital gains bracket. Luna: So the cash reserve dovetails with tax planning. You can refill it during low-income years to minimize taxes. Lucas: Exactly. Now, some critics argue that a cash reserve is just a suboptimal version of a bond tent — where you increase bond allocations before retirement and then slowly sell bonds to replenish cash. But a cash reserve is simpler and more transparent. You know exactly how many months of expenses you have. And for people who are not comfortable rebalancing a bond tent during a crash, a cash buffer is much easier to stick with. Luna: So you'd recommend this for someone who's within a few years of retirement or already in early retirement? Lucas: Absolutely. The ideal time to build the cash reserve is during the last two to three years of working, when you have high earned income. You can direct surplus salary into a high-yield savings account. That way you enter retirement with the buffer already in place. For someone already in retirement, you can build it gradually by directing a portion of your portfolio withdrawals to cash each year until you hit your target. Luna: Let's talk numbers. If your portfolio is one million dollars and you want two years of expenses at 40 thousand each, that's 80 thousand. That's 8 percent in cash. How does that affect your overall withdrawal rate? Lucas: If you're targeting a 4 percent withdrawal, you'd normally take 40 thousand in year one. With the cash reserve, you're holding 80 thousand in cash — which means your 'working portfolio' is 920 thousand. But you don't adjust the 4 percent rule for that. You still withdraw 40 thousand from your total portfolio, but ideally from the cash first. Over time, the cash gets replenished, so the portfolio remains mostly invested. The cash reserve has historically added less than a 0.1 percent drag to the overall spending power. Luna: So it's hardly a sacrifice for the peace of mind. Lucas: Right. And the behavioral benefit is huge. When the market drops 20 percent, most early retirees panic — especially in the first few years. Having a cash reserve that's separate from your account balances makes it easier to ignore the news. This couple said they barely checked their portfolio during the 2022 selloff. They just spent their cash. Luna: Are there any downsides besides the modest opportunity cost? Lucas: One downside is that cash can be tempting to spend on non-essentials. Some retirees dip into it for a vacation or a new car. That can erode the buffer faster than planned. You need the discipline to treat it as strictly for essential living expenses during a downturn. Another issue is that if you keep cash in a bank account that's not FDIC insured or in something unsafe, you risk losing it. But in a high-yield savings account or Treasury bill, that's not a problem. Luna: What about inflation risk? Cash loses purchasing power over time. Lucas: That's true, but the cash reserve is only a small fraction of the portfolio, and you replenish it frequently. Over a two-year holding period, inflation at 3 percent means you lose about 6 percent of purchasing power on that cash, which is maybe 4800 dollars on 80 thousand. That's the cost of insurance. And you can mitigate it slightly by using I Bonds for part of the reserve — but I Bonds have a one-year lockup and a penalty for early withdrawal in the first five years, so they're less liquid. Luna: Fair point. So you'd recommend plain old cash or short-term Treasuries for full liquidity. Lucas: Exactly. Now, let's circle back to the couple's actual results. They retired in early 2021 with 1.2 million. They spent about 48 thousand a year, so 4 percent. By the end of 2022, their portfolio—excluding cash—was down to about 960 thousand. Their cash reserve of 80 thousand meant they had 1.04 million total. They spent 48 thousand in 2022, all from cash. By December 2023, the market had recovered and their portfolio was back to 1.15 million. Their cash was still about 35 thousand. So they essentially had a 30 thousand surplus relative to their starting point, factoring in spending. Luna: So the cash reserve didn't just prevent selling low — it allowed them to end 2023 with a higher net worth than when they started. Compare that to someone who sold stocks in 2022: they'd have locked in losses and missed part of the recovery. Lucas: That's the crux. The cash reserve is a simple but effective tool to navigate sequence risk. It's not the only tool, but for many early retirees, it's the easiest one to implement. Next time we'll look at how a bond tent compares in a similar scenario, and whether you might want one over the other. Luna: Looking forward to that comparison. For now, I'm thinking about moving a portion of my own taxable account into cash before I pull the trigger. Lucas: Sounds like a smart move. Thanks for listening, and we'll catch you next time.