Executive Summary
Cash reserve strategies that hold aside several years of spending to avoid liquidations during bear markets are a popular way to manage withdrawals for retirees. In theory, the strategy is presumed to enhance risk-adjusted returns by allowing retirees to spend down their cash during market declines and then replenish it after the recovery. Yet recent research in the Journal of Financial Planning reveals that the strategy actually results in more harm than good; while in some scenarios the cash reserves effectively allow the retiree to "time" the market by avoiding an untimely liquidation, more often the retiree simply ends out with less money due to the ongoing return drag of a significant portfolio position in cash. As a result, the superior strategy for those who want to alter their asset allocation through market volatility (the effective result of spending down cash in declines and replenishing it later) appears to be simply tactically altering asset allocation directly, without the adverse impact of a cash return drag. Nonetheless, this still fails to account for the psychological benefits the client enjoys by having a clearly identifiable cash reserve to manage spending through volatility - even though the reality is that it results in less retirement income, not more. Does that mean cash reserve strategies are still superior for their psychological benefits alone, even if they're not an effective way to time the market? Or do total return strategies simply need to find a better way to communicate their benefits and value?
The inspiration for today's blog post is a recent article entitled "Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies" authored in the Journal of Financial Planning by Walter Woerheide and David Nanigan of The American College (and covered originally in the May 19/20 edition of Weekend Reading for Financial Planners on this blog). In their research, Woerheide and Nanigan examined the impact of so-called "buffer zone" strategies - essentially, strategies that hold aside several years' worth of withdrawals in cash reserves to avoid the need to liquidate during a market decline - and found that despite their popularity, such an approach actually hurts the sustainability of retirement income far more often than it helps!
The Buffer Zone Study
In order to test the impact of cash reserve strategies, the authors assumed the client holds a side reserve of several year(s) of cash (1, 2, 3, and 4 years of reserves were tested), with the rest of the assets invested in portfolios of varying equity exposure (0%, 25%, 50%, 75%, and 100% in equities were tested). The sustainability of the withdrawals were tested using actual sequences of stock, bond, and inflation results (consistent with other safe withdrawal rate studies) over the time period from 1926 to 2009, for withdrawal rates from 3% to as high as 9% (tested in 1% increments).
In terms of the cash reserve account itself, the authors simply assumed that if the overall portfolio was down, withdrawals would be taken from cash. If the portfolio return was positive, withdrawals would be taken from the portfolio, and a further amount would be liquidated to replenish any prior withdrawals from the cash account.
The results revealed that the failure rates for the buffer zone strategies increased compared to a baseline where there was no buffer zone. Success rates were uniformly lower, with the most extreme negative impact for longer withdrawal rate time horizons (e.g., 25-30 years versus only 15-20) and for higher withdrawal rates (e.g., 7%+ withdrawal rates versus only 4%-5%). In a detailed analysis of the underlying scenarios, the authors noted that there were a few scenarios where the buffer zones performed better (especially amongst the 2-, 3-, and 4-year buffer zone strategies); however, the no-buffer-zone portfolios were more successful almost 5 times as often!
Are Cash Reserve Strategies A Mirage?
The somewhat surprising results of the buffer zone study reveal that in the end, having a significant portion of the portfolio in cash creates so much of a drag on long-term returns, that the end result is a less sustainable portfolio (which is why the effect is especially severe at higher withdrawal rates and/or longer withdrawal time horizons where eventually getting equity returns, even after an extended bear market, are important). After all, at a 4% withdrawal rate, having 4 years of withdrawals draws nearly 1/6th of the entire portfolio into cash, which takes a material portion of long-term return off the table.
These results occur even though the retiree avoids taking withdrawals during down years in the portfolio by using the cash reserve account. In point of fact, this shouldn't necessarily be surprising - as noted previously on this blog, the reality is that in a regularly rebalanced portfolio, cash reserve strategies are generally unnecessary to avoid selling stocks in a bear market, as the act of rebalancing alone ensures that withdrawals are always taken from the higher returning asset class.
Certainly, it's possible to construct scenarios where everything in the portfolio declines simultaneously, and then rebounds simultaneously to a new high, such that it would have been better to draw from the cash reserve in the down year and then replenish it after the recovery. However, the significant and uniform decline in success rates across the board makes it clear that in the end, rebalancing alone is most often sufficient to ensure that the right investments are sold, such that adding a significant cash reserve is more a drag on returns than a savior of them.
In fact, in extended bear markets, it's actually possible for the buffer zone strategies to cause even more damage than systematic withdrawals. For instance, if the client has a 3-year cash reserve and experiences a 3-year bear market with a moderate bounce at the end (e.g., a portfolio return sequence of -5%, -10%, -20%, +10%) then given how bear market returns compound, the client would actually have had a higher average sales price by simply liquidating a portion of the portfolio each year, rather than taking replenishing the cash reserve bucket with three years of spending after only a slight rise from the bottom. This is effectively equivalent to selling out three years of spending near the bottom all at once, bulking up the portfolio's cash holdings before the full recovery occurs!
The Timing Of Cash Reserve Strategies
Some readers may take issue with the particular strategy the authors used to replenish cash reserves. Would it have been better to limit the sale from the portfolio from cash reserves until the portfolio recovered to its prior highs? Should a larger cash reserve bucket have been used, along with a requirement of two years of recovery before restoring it? Could some other formula have been applied that would have had a less harmful timing impact than the consequences of a 3-year bear market on a 3-year buffer zone as shown in the earlier example?
Perhaps, but if the fundamental point is to utilize a buffer zone approach as a market timing strategy to tilt equity exposures upwards or downwards by 5%-10% (by depleting and replenishing a 2-4 year cash reserve) to generate higher returns or reduce risk, then the same could be accomplished without the cash reserves, simply by adjusting equity exposure of the entire portfolio! For instance, "Improving Risk-Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies" in the December 2011 issue of the Journal of Financial Planning showed how tilting equity exposure up or down based on market valuation can enhance both returns and risk-adjusted returns, but without reducing the long-term return of the portfolio with a hefty allocation to cash (which the buffer zone study reveals is very harmful). Similarly, the April 2009 issue of The Kitces Report showed how more dynamic asset allocation strategies can directly increase sustainable withdrawals, in direct contrast to the cash reserve strategy's impact that lowers withdrawal sustainability due to the cash drag.
Behavioral Implications Of Cash Reserve Strategies
Notwithstanding some of the mathematical challenges of using cash reserve strategies, because of the return drag caused by the buffer zone cash is most often not made up by the timing of portfolio shifts, it is still true that for many clients, the cash reserve strategy is psychologically appealing. As many planners who have used the approach have witnessed first hand, clients simply seem to react more calmly to market volatility when they can clearly see where their withdrawals will be coming from over the next several years while waiting for a market recovery. The approach appeals greatly to the mental accounting tendencies documented in the behavioral finance research.
After all, if the reality is that the client cannot tolerate the volatility of the portfolio and will sell out at the bottom if there's not a cash reserve, then clearly the cash reserve strategy will be superior, given the tremendous "negative alpha" implied in clients who cannot stay the course and are prone to panic-induced action. Similarly, even the buffer zone study shows that if the client's alternative is to be 100% in bonds due to fears of the markets, then even a conservative 25/75 (equity/fixed) portfolio using buffer zones is far more sustainable.
The Bottom Line
In the end, the reality is that while cash reserve strategies appear psychologically appealing, their actual benefits as an enhancement for retirement income sustainability appear to be a mirage upon closer inspection. The buffer zone approach appears to do little to effectively "time" the market, and/or to the extent it does, the benefits are overwhelmed by the adverse consequences of a large allocation of cash in the portfolio that drags down long-term returns. Notably, though, separate research has shown that shifting equity exposure in light of market volatility (and based on fundamental valuation principles) can in fact enhance both returns, risk-adjusted returns, and the sustainability of retirement income - and without the unfavorable impact of an unduly large cash position.
Nonetheless, the challenge remains that such strategies are not always comforting for clients who may be fearful in the midst of market volatility, and while buffer zone strategies are inferior to safe withdrawal rate strategies of comparable asset allocation, they are still superior to scenarios where clients either panic-sell in a market decline and/or are unwilling to invest in equities in the first place. This suggests that ultimately, cash reserve strategies shouldn't be dismissed entirely, as it depends on how willing and comfortable the client would be to maintain the non-buffer-zone strategy in the first place. Alternatively, it may also be desirable to find a way to better communicate non-buffer-zone strategies in the first place, so that there is less of a psychological aversion to what appears to be the superior research-based strategy.
So what do you think? Is the cash reserve strategy just a mirage? Is it worth selecting a strategy that produces less income for clients if it does so in a more psychologically comforting manner? Is there a way to recast more traditional total return approaches so that they appear more like buffer zone strategies without taking on the drag of a large cash allocation? Are tactical asset allocation strategies that accomplish a similar result to the buffer zone approach but without the cash drag a more viable alternative?
Has anyone seen a response or commentary by Harold Evensky related to this and the other reports taking the cash reserve strategy to task? If you’re not familiar with his association with this strategy he devoted an entire chapter in his book: Retirement Income Redesigned – to what he calls the Evensky and Katz Cash Flow Reserve Strategy (E&KS) which is a form of the buffer strategy. They stress-tested this strategy against a 1970’s environment when both bonds and stocks were devastated and inflation was rampant. The E&KS portfolio vs. 100% bond vs. 50/50 stock/bond mix. Withdrawal rates were set a 4.5%. Rebalancing parameters were set at 10% and appropriate tax rates for ordinary income, capital gains and an inflation value were assigned to the test. EK&S provided superior performance in this scenario as well as their actual experience with the strategy during the 1987 drop as well as the 2000 and 2002 equity bear markets. He does mention quite clearly that clients react positively to the clear visibility and reliability provided by having the client able to see that their cash needs are set aside during tumultuous economic times so perhaps one needs to assign some, perhaps significant…value to that.
I have personally used the cash reservoir method since retiring in 2005. My portfolio is still above its original inflation-adjusted value.
One variable models don’t incorporate is the value of tax INFLOWS. In Canada we can recover past capital gains taxes in years of losses. The tax recoveries in 2008 funded about a full year of my costs.
You can check yourself how the system survived the VERY rare event of 3 years of back-to-back losses that was mentioned in the article. The spreadsheet’s (second page) default that starts in 1938 includes just such an event, and the portfolio is still going strong.
http://www.retailinvestor.org/Retire.xls
“Is there a way to recast more traditional total return approaches so that they appear more like buffer zone strategies without taking on the drag of a large cash allocation?”
I think yes. Establish a conservative “defensive reserve” rather than a cash reserve — perhaps targeting 10% downside risk at the second std dev. This lessens the cash drag. If the combined asset allocation of the defensive reserve and the long-term portfolio match the appropriate target allocation for a sustainable withdrawal portfolio, then you possibly achieve the results cited in the Woerheide/Nanigan paper AND the behavioral and mental accounting benefits of the reserve.
Cash is just a bond with a very short term duration. The paper assumes an extremely low yield (1 month T bill) for the cash buffer. In my Credit Union account currently I can get a yield 5 to 10 times the current 1 month T bill yield. The rate is somewhere between the 3 and 5 year Treasuries yield. That would make a big difference in the cash “drag.” In other words, it all depends on how low yielding the buffer is.
Since the riskiest time or a retiree is the first few years of retirement (say, the first five years), I wonder if the cash reserve strategy would work better if it simply was not replenished. That is, if the retiree simply spent if the portfolio was down, but actually invested that current year’s cash if it were not. So that at the end of those first few years, he was out of cash entirely but had weathered the tricky initial years of retirement.
FYI, in the "Behavioral Implications Of Cash Reserve Strategies" section, the sentence containing "because of the return drag" doesn't seem to be parsable. It seems that that "because of the" should be just "because the".