Life After Full-time Work Blog

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#71 A Liquidity Reservoir Creates Flexibility

If it’s possible, it helps a lot to have some money set aside for emergencies. In fact, as we’ll see in this post, a bit of cash also helps enormously to smooth out the impact of investment fluctuations. 

 

Financial professionals often recommend that you hold a few months’ worth of spare cash in case of emergencies. That way if something unexpected happens you can cope with it right away and don’t have to change your other plans.

In this post I’m going to expand on that idea, in the particular context of being able to create a barrier between investment value fluctuations and being forced to make your spending plans fluctuate in response. In Post #67 (https://donezra.com/67-happiness-comes-from-certainty-about-not-outliving-your-assets/ ) we discussed the way in which certainty creates happiness. Well, to the extent you can insulate your lifestyle from the inevitable ups and downs in the value of your pension pot, that will create great happiness.

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In theory, what you do is to periodically (weekly, monthly, yearly, whatever) cash out a sufficient amount from your pension pot to cover your spending until the next withdrawal (or “drawdown,” as it’s often called). But fluctuations in your pot’s value cause a problem. Here’s why.

If your rule is to cash out a fixed proportion each time, then fluctuations in the pot’s value will cause your drawdowns to fluctuate. And that means your spending will need to fluctuate in the same way. Bad news! “Last month the market really dropped. This month you need to really drop your spending.” Not made for happiness!

If instead your rule is to cash out a fixed spending amount each time, then you are subject to what the techies call “sequence of returns risk.” In a nutshell, here’s how it happens. Suppose you get a very low return in the first year, followed by a very high return in the second year. On average, looking solely at your returns, you’ll have achieved an average return over the two years. Satisfactory, you may think at first. But looking at your returns turns out not to be useful. That’s because, during the first year’s low return, you have to cash out a bigger-than-expected proportion of your pot in order to generate your spending. That leaves a smaller amount in the pot than expected. And though in the next year we’re assuming a high return, there’s less money for it to work on, and so you don’t make up the shortfall. In fact, if there are low returns for a few years at the start, your pot may shrink very rapidly, and you may never recover. Again, not a formula for happiness.

So the ability to insulate yourself from the effects of those fluctuations becomes particularly important in the drawdown phase of life. And that’s where the notion of a liquidity reservoir comes in.

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In investment terms, liquidity refers to assets that are already in cash, or can be converted to cash quickly and at virtually no cost. For example, a bank checking account is liquid. A one-year bank term deposit is slightly less so, because typically it involves a small penalty to convert it to cash.

Publicly traded equity investments are technically thought of as liquid, because they can be quickly converted to cash with a very small transaction cost. But for retirees they have a very negative feature, which is that equity value fluctuations mean that the amount available to you fluctuates too. If you own $10,000 worth of equities that you are considering cashing in, and a few months later they have fallen in value to $9,000, it’s not much consolation to be told that you can now get that $9,000 converted to cash quickly. You feel as though the cost of cashing out is $1,000.

It’s even worse if you needed that $10,000 for a particular set of expenditures, because now you feel the panic of having to rearrange your plans suddenly. And that’s why retirees typically don’t go directly from assets to spending. They create a liquidity reservoir in between.

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Here’s what I mean.

They create and maintain a pool, a reservoir, of liquid assets: cash or a bank checking account. This holds more than they plan to spend in the near future. Periodically they draw down some of their pension pot and put the proceeds in the reservoir. And then they take money out of the reservoir for spending.

Why do they do this? Because they don’t want asset value volatility to have an immediate impact on spending. Forced volatility in their spending is something they fear. And so the reservoir gives them a sort of cushion, smoothing out the spending. Even if the drawdown is somewhat volatile, spending itself doesn’t have to be volatile. Spending volatility should be much less than drawdown volatility.

In effect, by creating a reservoir they have given themselves a bit of insurance against being forced to cash out at a bad time.

It’s even better, in the sense of enabling you to sleep better at night, free from worry, if the drawdown amount is itself less volatile than the value of your pension pot. In other words, whatever the fluctuation in asset values, the drawdown shouldn’t be forced to be equally volatile.

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Let’s put this together and understand it well, because it’s a fundamental driving force, as far as the psychology of money is concerned.

It’s acceptable for the pension pot to be volatile, provided we can find a way to insulate the drawdown from at least some of that volatility. (There are ways to do this — too complex for this post.) And then we can further insulate the actual spending from the drawdown’s volatility, via the creation of a liquidity reservoir.

So …

·     The pension pot’s value can be volatile;

·     The volatility of the drawdown can be made less volatile;

·     And the volatility of spending can be made still less volatile.

Or, in terms of smoothness:

·     Spending is smoother than drawdowns;

·     And drawdowns are smoother than pension pot asset values.

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Don’t misunderstand me. Ultimately, if there are low returns for a prolonged period, there’s no way to insulate yourself from their impact on your lifestyle. What the liquidity reservoir achieves is to give your investments time to recover from the typical short-term fluctuations that investments go through. But they do need a recovery; if none arrives, ultimately we all have to face the music. (This is called “relying on mean reversion.” Again, too complex for this post.) Another way of saying this is that the reservoir gives us protection against shallow risk, but not against deep risk, a distinction I explained in my Art of Investment column in the FT Money supplement to the Financial Times on January 28, 2016 (https://www.ft.com/content/75bca7ca-c360-11e5-b3b1-7b2481276e45).

In passing, let me say that it strikes me as unhelpful, if not downright bizarre, that the current state of the art with many financial professionals is to try to assess a retiree’s tolerance for asset volatility when, as we’ve just seen, asset volatility is hardly relevant, given the ability to reduce its impact on spending. It’s spending volatility that’s relevant, but risk profile questionnaires don’t typically get into that angle.

One final observation about the liquidity reservoir. Typically its purpose goes beyond reducing spending volatility. The money in the reservoir can be used for any purpose. In particular, it also serves as that emergency fund that we started this post with. So any form of emergency spending typically comes out of the reservoir. And, since retirees are typically wealthier than their children, or at least have a bigger emergency reservoir, it sometimes also gets used for children and grandchildren. This emergency purpose is another reason why a reservoir is such a good idea.

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Takeaway

A pool of cash can fulfill many purposes, from being a source of emergency funds to being a way to insulate your lifestyle spending plans to some extent from the inevitable fluctuations in the value of your pension pot.   

10 Comments


I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.


10 Responses to “#71 A Liquidity Reservoir Creates Flexibility”

  1. David Hartley says:

    Hi Don,
    Great to see you drawing out one of the flaws with “tolerance to volatility”, which we know fluctuates over time, and instead focussing on the purpose for which money is being held. As commonly practised the focus on tolerance to volatility effectively instructs people to sell shares after shares have fallen in price. It is not at all helpful.
    Keep up the good work
    David

  2. Stephen says:

    In my country (Australia), the matter is complicated by mandated minimum pension drawdowns that increase with age. Therefore, using the liquidity reservoir concept, you will discover that the reservoir keeps growing on a rolling basis not to accommodate spending requirements of the member but to satisfy the legislative requirements imposed on pension fund drawdowns. It introduces another variable into the equation – opportunity cost associated with a growing liquidity reservoir.

    • Don Ezra says:

      Thanks, Stephen. That’s a good point. Different countries have different rules, as you note. So the best one can do is think in terms of general principles. And my linear mind, which finds it difficult to exist in multiple frames of reference at the same time, leads me to the following sequence that I would follow, if this were my situation. I think the sequence is the same as yours, so I think we agree. But let me be explicit. (1) Follow the rules, exercising whatever flexibility they permit. (2) If, after doing that, I find I have too much liquidity (let’s say, cash), then I’d go into my risk framework, and reassess where I want to be in the safety-growth spectrum. If I’m closer to safety than I’d like to be, I’d make a partial shift in the direction of growth. This may not give me the same tax advantage that I had before, but it’s better than staying closer to safety than I’d like to be. To use your language, I’d presumably be uncomfortable with the opportunity cost of excessive liquidity. Hope that helps.

      • David Hartley says:

        I wonder if the solution for Stephen might involve some assets being held outside of the pension account so that if, for example, 6% needs to be drawn and only 4% is needed for spending, the other 2% goes into a share portfolio. This other 2% can be drawn from shares as it will be reinvested in shares.

  3. Cindy Deere says:

    Thanks Don. I really enjoy your posts and especially like this one. For me, it’s all about creating options to improve peace of mind and this speaks to that beautifully. I like the shift in focus from asset volatility (which we know will happen) to spending volatility (which we don’t want but sometimes pops up). Makes it very practical and resonates more. Keep the posts coming! Thank you!

  4. Ted Harris says:

    Having a volatility reserve is important, be it for income fluctuation or emergencies. If able, I would suggest that staggered reserves are also worth considering. One should have a liquid reserve for near term volatility and, ideally, a reserve that may be less liquid and may be required to generate income or cash in situations where more planning, as required, is possible. An example of the latter could be expenses related to longer term health and care issues.

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