You have many paths to choose from when it comes to investing for retirement. For example, you may consider real estate purchases, investing in mutual funds or exchange-traded funds, investing in the stock market and more. Some investors prefer to take a lower-risk path by having an all-cash portfolio or choosing investments such as money market funds, Treasury bonds, or certificates of deposit. However, if you need investment growth to support your long-term retirement needs, this path may not be the best option for you.
Many investors think owning a portfolio of 100% cash or lower-risk options like money market funds is a safer way to invest for retirement. It is true that cash investments have high liquidity and stability. They don’t experience the same fluctuations as the stock market. But is having your money in cash really a better fit for your situation?
First, consider the different types of securities available.
Money market funds: This type of mutual fund typically invests in high-liquidity, stable securities such as U.S. Treasury bills or highly rated debt securities. Money market funds have several advantages. Money market funds may offer check-writing capabilities, which can give extra flexibility. Money market funds also often generate a slightly higher rate of return than interest earned in a bank account, have relatively short-term maturities and can be easily accessible. You can invest in them directly through your brokerage account or from a mutual fund company.
However, money market funds generally have low yields when compared to investments in the stock market, aren’t insured by the Federal Deposit Insurance Corporation (FDIC) and may require annual fees, which could further eat away into the low yield. Money market funds are not 100% risk free, but generally it is fairly easy to sell them when you need to.
Note that money market funds and money market deposit accounts aren’t the same thing. Money market deposit accounts (also known as just money market accounts) are more similar to savings accounts. Unlike a normal savings account you might have at a bank, money market accounts often have certain minimum amounts to open the account and keep it active. Additionally, you might expect a higher interest rate than a regular savings account, but also have more limitations on things such as check-writing abilities. Money market accounts are insured by the FDIC.
To keep these straight, remember that money market accounts are, as the name suggests, a type of account, whereas money market funds are a type of mutual fund.
Bank accounts: Banks offer several options when it comes to depositing your money—checking accounts, savings accounts, money market accounts and so on. Banks often pay a lower interest rate than bonds or some other investments, but the benefit of having money in a bank account is its liquidity. You can access your money at any time. Another benefit: Your deposits are insured by the FDIC.
In spite of the safety and liquidity, keeping your money in a bank account can have drawbacks. You may earn lower returns than many other investing options, you may have to pay fees to keep your accounts open and, if the money is easily accessible, you may be tempted to spend rather than save.
Certificates of Deposit (CDs): These are fixed-income investments—you deposit a fixed amount to the bank that issues the CD for a specific time period, anywhere from a few weeks to several years. For your deposit, you receive a fixed yield, and when the CD matures you could get your principal plus accrued interest. You could also reinvest in a new CD. CDs are FDIC-insured.
Although CDs often pay a slightly higher interest rate than savings accounts, that return could be much lower if you put your money in a CD in a low-interest-rate environment. And if your current CD matures and interest rates are lower at the time you reinvest in a new CD, you could get stuck with a lower rate. Finally, if you liquidate the CD before it matures, you may be faced with a penalty.
The primary appeal of cash—stability—is also related to one of its biggest downside for many investors. Though it doesn’t necessarily lose value in the short term, cash offers little possibility of long-term growth. That may seem like a fine tradeoff when you see markets bouncing around on a day-to-day basis, but when investors need to invest for a future goal—such as retirement—most portfolios need some growth in order to account for inflation and a long time horizon. And for that, you need to be concerned about long-term returns when investing.
Volatility can be scary. But short-term market volatility doesn’t necessarily mean investors have to buy and sell stocks as the markets go up and down. While stocks can be volatile in the short term, their longer-term returns exceed cash significantly. Consider that from January 1st, 1988 to July 1st, 2019, the S&P 500 had an annualized return of 10.51%.[i] Investors may have to endure short-term volatility in order to capture stock’ longer term returns. Remaining in cash could rob your portfolio of the opportunity for your investments to increase in value.
Cash is the most liquid asset available. If you have money earmarked for a near-term expense such as an upcoming bill, necessary living expenses, or something like a down payment on a real estate investment, then a cash investment is probably the right call. However, investors whose primary goal is retirement planning, an all-cash portfolio could be the riskier option if you need growth in your investments. If you have a long time horizon, you may need some equity-like returns to fund your goals and future returns. If you don’t get the growth you need, you could run out of money late in life. A portfolio focused on cash investments subjects you to the risks of inflation, potentially jeopardizing your ability to reach your long-term investment goals. What your cash is worth today won’t be worth near that amount when it is time to retire.
Over time, cash loses purchasing power due to the effects of inflation. Historically, inflation has averaged almost 3% a year, eating away at the purchasing power of cash over time.[ii] Unfortunately we don’t live in a world of zero inflation. Retirees have to deal with the rising prices of health care services and other necessary expenses.
If you are planning to maintain a certain living standard while also accounting for expenses such as health care throughout retirement, cash as a retirement planning investment probably won’t cover your needs.
Additionally, with rising life expectancy, your entire time horizon may be longer than you expect. If you are entering retirement, that could mean you need your money to last 30+ years. Can a portfolio of cash investments provide enough for an investor to live off of? What happens if you live longer than you initially expected?
This article isn’t meant to completely deter you from keeping your cash assets, money market options or other cash investments. In some cases, it can be the appropriate choice. In our view, the question of whether an investment is “riskier” or “safer” requires evaluating your current needs and future needs, goals and time horizon. Don’t overlook the investing risk of failing to have enough money to meet your goals.
While everyone’s situation is different, an all-cash portfolio often only makes sense if your time horizon is very short—not the case for most investors. With so many investing choices, from investing in money market funds to mutual funds to real estate, making financial decisions for retirement planning can be daunting.
We have helped many investors with their retirement planning. If you have any questions or would like guidance on how to deal with the complexities of your situation, contact us today. We may be able to help.
[i] FactSet, Inc.; as of 07/02/2019. Daily S&P 500 Total Return Index from 01/01/1988 to 07/01/2019.
[ii] Source: FactSet, as of 2/25/2019; from 12/31/1925 to 12/31/2018, average annualized inflation was 2.90% based on the U.S. BLS Consumer Price Index.