Combining a year’s worth of cash with a long-term investment portfolio protects immediate needs while still enabling the portfolio to grow.
Given the headwinds of inflation, return sequence, and a low return environment, what’s an investor to do?
The traditional income portfolio (i.e., one that provides annual cash flow from dividends and interest) will not work for a number of reasons. First, the current level of interest rates and dividend yields has no relationship to what would be an appropriate retirement portfolio allocation. For example, the current yield on a 20-year A-rated corporate bond is about 3.9% and the yield on the S&P 500 index is 1.8%. For a client looking to achieve a 4% cash flow, that means his portfolio allocation would have to be 100% bonds. Of course, this would be a short-lived solution, as over time the purchasing power of the nominal return from bonds would be eroded annually by inflation. Plus, the investor’s income is variable as interest rates change. Not to mention that how the investor feels and the economic reality of the value of his or her portfolio move in opposite directions, exacerbating the situation. When rates are down, portfolio income decreases and the investor feels poor, even though the portfolio value would actually be increasing. When interest rates rise, portfolio income goes up and the investor feels richer, even though the reality is his or her bond portfolio value is dropping.
A viable solution must provide consistent real cash flow in a volatile, long-term low return market environment. It was with this in mind that we created the Evensky & Katz two-bucket approach back in the early 1980s. Here’s how it works.
An investor’s nest egg is bifurcated into separate portfolios: the Cash Flow Reserve (CFR) portfolio and the Investment Portfolio (IP). When originally designed, the CFR was funded with two years of cash flow needs; subsequent research at Texas Tech University determined that a one-year reserve was optimal. Figure 1 visually describes the strategy.
Figure 1. Evensky & Katz Portfolio Approach