Retirement Resources: Building a Cash Flow Reserve Ladder

We’ve all heard the age-old investment adage “buy low and sell high,” which describes the purchasing of assets when they are out of favor, and to sell when assets have risen and are in your favor. A major challenge that confronts retirees is how to avoid selling their hard-earned retirement assets at the wrong time. To combat this dilemma, a cash flow reserve (CFR) ladder, when used in tandem with a diversified portfolio, can provide stability and enable the flexibility to decide when to sell assets while preserving a steady income.

The Basics

A primary goal for retirees is to avoid being in a position of having to sell their retirement assets for less than their potential worth. This makes timing even more important for retirees since they are liquidating assets to support expenses and not reinvesting.

When structuring a retirement investment portfolio, there are two tenets that can be followed that may help achieve this goal:

1. Investing retirement savings in a well-diversified portfolio that includes cash, fixed income, and equity investments. Preferably, the equity investment allocation should focus on a high and growing dividend income stream.
2. Implementing a CFR ladder that can provide monthly income during retirement and can allow the retiree the ability to dictate when to sell assets. Historically, fixed income and equity assets have a tendency of being favorably priced at different times in the market, giving the retiree the ability to time the disposition of the retirement assets when it may be most optimal. Using a ladder structure that includes a cash flow reserve for near-term expenses, and both fixed income and equity assets for intermediate and longer-term expenses, is one structure that may help achieve this goal.

The consequences of not being diversified and then forced to sell into a bear market can be significant. Using a CFR ladder and being well diversified can provide a benefit during difficult retirement periods, included significant bear markets.

Structuring a Cash Flow Reserve Ladder

A CFR ladder is comprised of three “rungs” that strive to align the least volatile assets to meet the retiree’s near-term expenses while giving equity assets the opportunity to grow. This potential growth of the equity investments can offset the eroding effects of inflation on the retirement savings. As illustrated below, the three rungs include: a checking account, a cash flow reserve, and an investment portfolio. The targeted investment time horizon for each rung is shown across the middle, and the percentage of the longevity-oriented investment portfolio is shown along the top.

Hypothetical Cash Flow Reserve Ladder

A well-thought-out investment portfolio structure effectively manages investor behavior and positively influences investment outcomes. We’ll now review the various rungs of the CFR ladder:

Checking Account

On the first of each month, the retiree transfers funds from the cash flow reserve into the checking account to pay for expenses. This provides a monthly cash flow, which (from a behavioral finance perspective) is very healthy and allows the retiree to budget for monthly spending accordingly.

Cash Flow Reserve

The cash flow reserve is comprised of two years’ worth of spending needs in short-term assets, such as a money market account and/or a limited-term bond fund. The retiree draws a check from the cash flow reserve to deposit into the checking account at the beginning of each month. The relative liquidity of this rung can provide the retiree with the ability to cover two years of spending. Having two years’ worth of disposable assets can be key to helping alleviate ill-timed selling into a bear market. Once the distribution phase begins, we prefer to see dividend and interest income not reinvested during the year but rather transferred into the cash flow reserve. This naturally replenishes the cash flow reserve, and any excess can be reinvested at year end.

Investment Portfolio

Fixed income investments have historically performed better when equities are out of favor; therefore, having a balanced portfolio of fixed income and equity investments can help alleviate selling retirement assets at a less opportune time in order to fund retirement spending (when liquidated). In this rung of the ladder, there will typically be enough fixed income investments to pay for an additional four to five years of spending. Also included in this rung is an allocation to equity investments, which have historically been more volatile than fixed income assets but also have the potential for higher returns over time. While the equity investments may provide the necessary growth to help offset the eroding effects of inflation in retirement, retirees also need to have the flexibility to sell assets when the markets are attractively valuing those investments. The assets from this rung are used to replenish the funds in the cash flow reserve as needed. Again, the goal is to have the flexibility to sell either the equity or the fixed income assets at an opportune time without compromising a steady income stream.

Asset Allocation Alternatives

Now that we know the basic structure and operation of a CFR ladder, let’s discuss just a few of the many ideas for how the retirement assets can be allocated to each rung. The most appropriate investments will vary depending on an individual’s needs and investment objectives and should be discussed with a financial advisor. For illustration purposes, let’s assume a retiree has a $1 million portfolio and wishes to spend $50,000 each year, indexed to inflation.

In the example below, a 2000 retiree uses the Cash Flow Reserve Portfolio structure and chooses an Endowment Spending Policy to successfully navigate challenging investment periods. For taxable accounts, municipal money market funds and/or municipal limited-term bond funds can be attractive. Remember that the primary goal of this rung is principal protection.

Cash Flow Reserve Strategy Illustration (2000-2024)

The investment portfolio is divided into two separate components. The $250,000 allocation to fixed income represents 25% of the assets and, if need be, can provide up to five years of additional spending at $50,000 per year. The intermediate-term bond fund portion has a time horizon of five to 10 years, and should be conservatively managed with a primary goal of principal protection.

The $650,000 in the equity portion of the investment portfolio represents 65% of the overall asset allocation of the portfolio. This portion is intended to provide the possibility of long-term growth that may offset the eroding effects of inflation. The CFR ladder approach allows the retiree time to liquidate these assets into potentially more favorable markets. Using a high and growing dividend-paying stock fund in this rung may provide the benefits of a growing dividend stream (to contribute to the current income needs of the retiree) and the potential growth that is historically associated with equity investments.

Let’s return to the hypothetical retirement that began on January 1, 2000. At that time, the retiree chose to spend $50,000 per year and indexed to inflation. The following table illustrates the values of the hypothetical portfolio and the different allocations as they appeared on January 1 of the first, 10th, and 20th year of retirement.

Figure 4 | Hypothetical Retirement Account

Breaking it Down

On January 1, 2000, the retiree had just transferred $4,167 into the checking account to cover the monthly expenses, with $95,833 in the cash flow reserve, and$900,000 in the investment portfolio for a total value of $1 million. The current year’s spending is the $4,167 times 12 months for $50,000, and the spent-to-date amount is zero since the retirement just started. Moving through the years to January 1, 2009, following the significant declines of 2008 (financial crisis), the retiree had just placed $5,383 in the checking account, and the cash flow reserve was down to $77,230 since a decision was made not to sell any of the assets in the investment portfolio in late 2008 to replenish the cash flow reserve. The preference was to hold off selling any assets until the markets stabilized. The total portfolio was down to $905,832, which approximates the $1 million originally invested in the portfolio. Not to be forgotten, the retiree has spent $502,247 during the first 10 years of retirement and the current spending rate is 6.5%. This rate, although a bit elevated, is still reasonable given the recent poor market performance, but will have to be watched closely in the following years.

By the beginning of January 2020, the account had recovered nicely to $2.19 million in value, given improved market conditions. In addition, the retiree was not forced to sell any of their retirement assets during the 2008 bear market at depressed prices. Monthly spending for 2020 is up to $6,388, and the current withdrawal rate has been reduced to a very healthy 3.5%. All in all, the CFR ladder performed well, given the very challenging markets that have impacted this 20-year hypothetical retirement period.

Key Takeaways

Utilizing the structure of a CFR ladder with a well-diversified portfolio during the distribution phase of retirement can provide retirees with the necessary foundation and discipline to alleviate selling their retirement assets into a bear market. The cash flow reserve has the ability to provide two years of liquidity, thus allowing expenses to be met readily. The investment portfolio has a mix of intermediate-term fixed income and equities focusing on a high and growing dividend income stream that may be liquidated during opportune times in the market to refill the cash flow reserve. This type of structure can help the retiree stay on plan and meet expenses.