Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How Early Retirees Use a Cash Buffer to Avoid Selling Low
Transcript
- Lucas: So we've talked a lot about withdrawal rates, sequence risk, flexible spending floors. But there's one tool that a lot of early retirees swear by that we haven't really dug into yet, and it might be the simplest one of all. Luna: A cash buffer? Lucas: Exactly. A cash buffer. And I know it sounds almost too basic to be worth an episode, but the more I look at the math, the more I think it's the unsung hero of early retirement income planning. The idea is you keep two to three years of living expenses in cash, and you spend from that instead of selling investments when the market is down. Luna: So it's like a bridge over a rough patch. You don't touch your stocks when they're on sale. Lucas: Right. And the beauty is you don't need to predict the market. You just need to have the cash on hand so you're not forced to sell at the worst possible time. Let's make it concrete. Say you have a one-million-dollar portfolio and you're withdrawing forty thousand dollars a year, which is the classic four percent. If you keep a hundred twenty thousand dollars in cash, that's three years of expenses sitting in a high-yield savings account or a short-term Treasury ladder. Luna: And that cash earns something, but not much. Right now you might get four and a half percent on a savings account, which is not nothing, but it's below what you'd expect from stocks over the long run. Lucas: That's the trade-off. You're accepting a lower return on that slice of your portfolio in exchange for stability. But the real payoff comes when the market drops. Suppose the stock market falls thirty percent in a year. If you have a sixty-forty portfolio, your stocks go from six hundred thousand to four hundred twenty thousand. Your total portfolio drops to seven hundred twenty thousand. But you're not selling any of that at the low because you're spending from your cash bucket. Luna: So your cash bucket shrinks, but your stock holdings stay intact. Then when the market recovers, you can refill the cash bucket by selling some stocks that have recovered. Lucas: Exactly. And the math works out better than you might think. If you have three years of cash, you can ride out most bear markets. Historically, the average bear market lasts about a year, and even the worst ones are usually over within three years. So by the time you need to refill the bucket, the market is likely well off its low. Luna: I love that it's not about timing the market. It's about buying time. It's giving your portfolio a chance to recover without you being forced to lock in losses. Lucas: Yeah, and that's the key insight. A cash buffer is not a market-timing tool. It's a risk-management tool. And it's especially powerful for early retirees because they have a longer horizon. The last thing you want is to sell low in the first few years of retirement and then run out of money thirty years later because you never recovered from that early hit. That's sequence risk. Luna: We've talked about sequence risk before, but this is such a hands-on way to address it. It feels more actionable than just 'be flexible'. Lucas: Absolutely. And it pairs beautifully with the flexible spending floor we discussed in episode one fifty-five. If you have a floor that lets you cut spending by twenty percent in bad years, your cash buffer can be even smaller. Maybe two years instead of three. The two concepts work in tandem. Luna: So how do you actually fund the buffer in the first place? Do you build it before you retire, or do you dollar-cost average into it after you retire? Lucas: The cleanest way is to build it before you pull the trigger. You've got a few years of high savings rate anyway, so you can divert some of that into a cash account. But for people who are already retired and didn't plan ahead, you can also build it gradually by taking your normal withdrawals and setting aside the cash until you've got that two or three years of reserves. Luna: And if you're in a bull market at the start of retirement, you might be selling stocks that have gone up a lot. That's a good problem to have. Lucas: Right. You're selling high, which is exactly what you want to be doing. The buffer just makes sure you're never selling low. So it's not about avoiding selling altogether. It's about being deliberate about when you sell. Luna: And I suppose the cash buffer also gives you peace of mind. I mean, there's a psychological benefit to knowing you've got three years of expenses sitting there. It's like a security blanket for your retirement. Lucas: That's a huge part of it. Behavioral finance shows that investors who don't panic during downturns tend to do better, because they don't make rash decisions. Knowing you have cash can help you stay the course. And that's not a small thing. Lucas: But let's address the elephant in the room. Holding cash has an opportunity cost. If your long-term return on stocks is, say, seven percent and cash is earning four and a half, then over twenty years, that hundred twenty thousand could have grown to almost four hundred thousand if it had been invested. That's a real cost. Luna: But you're not holding it forever. You're refilling it when the market is up, so it's not like you're permanently missing out on that growth. It's just that portion of your portfolio that's temporarily in cash. Lucas: Right. And you can minimize the drag by keeping the buffer in assets that earn a decent yield, like a short-term Treasury ladder that's maturing every month or two. You could get a bit more than a savings account, and you know exactly when each rung matures. Luna: So it's like a mini bond ladder, but for cash flows. You've got a rung maturing each month to fund your living expenses, and the rest is earning something until you need it. Lucas: Exactly. And some people use I bonds, which are inflation-protected and have tax advantages for education, but for early retirees the short-term Treasury ladder is probably the most straightforward. You can set it up so that a rung matures every month, and you use that to pay your bills. Luna: And if the market is down when a rung matures, you just don't buy a new rung. You let your cash balance go down until the market recovers. That's the beauty of it. Lucas: Right. And you can also use a high-yield savings account for simplicity. The yield is a bit lower than a Treasury ladder, but it's one less account to manage. For someone who values simplicity, that might be worth the small cost. Luna: Now, how do you decide between two years and three years of expenses? Is there a rule of thumb? Lucas: I think it depends on your spending flexibility and your risk tolerance. If you have a fixed spending floor and you can't cut back much, you might want three years. If you have flexibility to trim expenses in a downturn, two years might be enough. And also consider how long bear markets have lasted historically. The longest was the dot-com bust, which lasted about two and a half years from peak to trough. So three years covers that, two years might just barely miss it. Luna: So for the cautious retiree, three years is safer. But there's a cost to that caution, as we said. Lucas: There is. And that's a personal trade-off. But the buffer doesn't have to be static. You can adjust it over time. If you've been retired for five years and the market has been good, you might feel comfortable reducing it to one year. Or if you hit a bear market and your portfolio drops, you might want to increase it to give yourself more runway. Luna: It's a dynamic tool. It's not set-and-forget. Lucas: Exactly. And that's what I love about it. It's not a rigid rule, it's a strategy that adapts to your situation and the market. And it works hand in hand with everything we've talked about on this show, from withdrawal rates to tax planning. Lucas: And you know, thinking about this episode, it's a good reminder of why we do this show. We want to give you concrete, actionable ideas that make a real difference in your financial life. And that's why we keep it ad-free. We're not trying to sell you anything. The only thing we ask is that if you find value in these conversations, and you want to help us keep them free from sponsors, you can support us at buy me a coffee dot com slash fexingo. That's it. No pressure, just a simple way to say 'thanks' and keep this going. Luna: Yeah, and every little bit helps us keep the lights on and the microphones working. Lucas: So, back to cash buffers. One common question is, should you include the cash buffer in your portfolio when calculating your withdrawal rate? I think it's cleaner to keep it separate. Your four percent withdrawal should be based on your invested assets, not your cash buffer. Otherwise, you might be under-withdrawing or over-withdrawing without realizing it. Luna: That makes sense. If you include the cash, you might think you have more than you do, or the withdrawal rate gets skewed. Lucas: Right. So you've got your investment portfolio that's meant to grow and provide income, and you've got your cash buffer that's just there to smooth out the bumps. Two separate buckets, each with a job. Luna: And when you refill the cash buffer, you're selling investments, which could have tax implications. Do you have any advice on that? Lucas: Good point. If you have a mix of taxable and tax-advantaged accounts, you want to be strategic about which assets you sell to refill the cash. In general, you want to sell from your taxable accounts first to take advantage of capital gains rates, and then maybe from tax-deferred accounts if you need more. And you can also use the buffer to manage your tax brackets, like selling just enough to stay in the zero percent capital gains bracket if you have room. Luna: So it's not just about avoiding selling low, it's also about tax efficiency. Lucas: Exactly. And that's another reason why a cash buffer is such a versatile tool. It gives you time and options. Instead of being forced to sell something you don't want to sell, you can wait and choose the best time from a tax perspective as well. Luna: Lucas, this has been really helpful. I feel like I have a much clearer picture of how a cash buffer works and why it's worth considering. Lucas: Glad to hear it. And I hope our listeners do too. If you're in the middle of planning your early retirement, or even if you're already retired, a cash buffer is one of those decisions that can make a world of difference. It's not flashy, but it's effective. Luna: And it's a perfect example of how sometimes the simplest strategies are the most powerful. Lucas: Couldn't agree more. So, next time you're looking at your portfolio, ask yourself: do I have a plan for the next bear market? If not, a cash buffer might be your answer.