Trim to Spend

Last week we talked about market predictions for this year and what they mean (more or less) for current savers. This week let’s review how this relates to retirees and those nearing retirement.

In a sense, savers have it easy; it’s all about accumulation. Buy shares, monitor, rebalance, and let the power of compound interest work its magic. Making the transition from saving to spending is more complicated, however, so let’s dive into some of the details for this year.

Assuming you have a balanced portfolio of stock and bond investments, the first step in planning for the year ahead should always be assessing near-term spending needs. This is a critical step that many investors avoid for various reasons. One of those is figuring out what to do with cash so let’s start there.

First, “cash” in this context refers to ready cash at the bank and cash equivalents like money market funds, bank CDs, and US Treasuries maturing within 12 months. The investment return, or yield, on cash has moved around quite a bit in recent years, from near-zero during Covid to maybe 5% a couple of years ago, to around 3.5% now. That’s a lot of movement that can leave some investors feeling like they’re always behind the curve.

That said, while I’m a believer in trying to maximize your cash as much as possible, the return on your cash is ultimately less important than the return of your cash when you need it.

A big part of the yield swings on cash has to do with changes in Federal Reserve policy. The Fed controls a short-term interest rate benchmark that drives much of the market (and economy) and they’ve lowered this a few times in their current easing cycle. Currently, the market is expecting the Fed to lower its rate benchmark by another quarter to half percentage point this year. This means yields on cash are likely to continue lower, assuming everything plays out according to expectations (which can be a big assumption).

So, what should you do about generating cash from your portfolio?

First, I suggest totaling up what you might need from your investments this year. Then subtract expected portfolio income like dividends and interest. I have all this information for clients, and your brokerage firm should as well if you’re managing your own portfolio.

In general, the current dividend yield of the S&P 500 is about 1.1%. Your yield might be different depending on when you bought shares, so you’ll want to check. Large Cap dividend-oriented funds pay close to 5% and core bonds pay about 4.2%. Bank CDs or Treasuries might still be paying 4% or so based on when you bought them but currently pay around 3.5%. Depending on your portfolio mix, all this might average out to 2% or 3% average cash flow over a year.

If that’s all you need and it’s happening in the right type of account, then that’s great. But for many people it’s not quite enough and happens across multiple account types, so they need to sell investments to cover the difference.

If so and going back to recent weeks when we’ve talked about (potential) excesses in the AI-related world, now is a great time to trim back your stock positions weighted to this area. Trimming can be accomplished through selling some of your S&P 500 index fund, total market fund, or other large cap stock fund, especially if it holds more tech exposure.

How much do you sell? I suggest trimming back to your target large cap stock weighting, assuming you have one. At the sector level, I suggest targeting around 25% of your stock exposure to Tech and around 5% or so to Communication Services, dropping about a third off what the S&P 500’s weighting is for the two sectors now and looking more like it did before the AI craze took off. Then if you need more cash, look at other parts of your allocation that could be out of whack, such as foreign stocks, and trim those back to target weightings. Beyond that you can sell bonds or sell across your portfolio while emphasizing trimming from stocks.

Now, this is all relatively straightforward within a retirement account because you don’t need to worry about capital gains and losses. The downside is that every dollar you withdraw from an IRA or 401(k), for example, is taxed as ordinary income. Because of this, know that you can and should protect money within your retirement account for future spending, but that doesn’t mean you have to take it out all at once. If you’re of RMD age, certainly take that as a minimum, but try not to take more than you really need each year since it’s all taxable.

If you’re trimming stocks within your non-retirement account, always check your cost basis information first. Are you selling something at a gain? If so, do you have different “lots” to sell at lower gains, or perhaps you have losses that could offset gains? Perhaps you’ll decide to keep the overweight positions in your non-retirement account for tax reasons and sell from your IRA instead. That adds complexity to the process but it’s not too bad and I can help if you’re DIYing it.

Okay, now you’ve set aside cash for the year. What do you do with it in the meantime?

As I mentioned already, yield is secondary to having liquidity accessible where and when you need it, but it’s a strong second! Try to make your cash work as hard as possible in the context of keeping it safe. To me, this means no crypto and precious metals because they’re way too volatile and avoid investments that tie up your money like cleverly sold annuities. This leaves us with three categories, but really two right now:

Money market mutual funds – Schwab’s Prime Advantage currently pays about 3.5% and Vanguard’s Cash Reserves pays about 3.6%. These are just two examples of many that show you where the market is. Look at the “7-Day Yield” for your available options as a standardized way to see what they’re paying now. Remember the yield isn’t guaranteed for any timeframe and should be expected to change along with Fed policy and the market in general. (Workplace plans usually have a “stable value” option instead of a money market fund, but it’s the same thinking.)

Bank CDs – I’m seeing 1yr CDs at about 3.75% this morning and US Treasurys at about 3.6%. To me, these are interchangeable when we’re talking about short-term maturities. Yields are guaranteed to their individual maturity dates and federally insured in the case of CDs. Just hold these until the maturity date and volatility isn’t an issue. Check with your bank as well, but you can easily and cheaply buy either within your IRA and non-retirement account at competitive yields.

The bond market – Typical short-term bond funds like Vanguard’s ticker symbol BSV are paying essentially the same as other cash instruments but with some market risk and no specific maturity date. While they also come with some upside, I suggest avoiding bond funds for your short-term cash because of the market risk.

There you have it. Hopefully this helps as you do your portfolio planning. I’m doing these sorts of things for my ongoing clients every day and can help you if needed. Otherwise, good luck as we navigate what’s already shaping up to be a positive but volatile year.

Have questions? Ask us. We can help.