A practical discussion on the use of an 'income-reserve' or 'cash buffer'..

[Wizard]

I don't use an HYP, but this issue of cash reserves applies to any portfolio that someone's living off. It's well worth giving it plenty of thought IMO.

I draw my own 'dividends' to my own level and timing out of total returns using yearly capital gains tax allowance and tax harvesting practices. Supplemented with a company pension comparable to the yearly income tax allowance amount. With relatively low dividends - £2000 or less, and they're also tax free (low yield portfolio). A relatively low safe withdrawal rate (SWR) by its nature provides a relatively safe steady/regular inflation adjusted income that you draw no matter whether the portfolio is up, down or sideways. More worthy of thought is when to draw (top up cash account) - as opportunities present themselves. With a standard SWR you might draw once yearly, or even monthly, but you can revise that to draw maybe two or more years of SWR if the portfolio has performed well, or not at all if the portfolio is down and there is sufficient in your cash account. Cash reserves are just a cash account, requiring little thought, better than carrying cash around in a wallet.

Hardly relevant to this board, but thanks for the insight. Most here would prefer not to wrestle with decisions imposed by capital downturns such as 2008 and now, and this board is no place to propose an alternative to HYP.
I trust we will not feel the need to discuss this further.

Arb.

I think there are some elements of this post that are worth considering, if I understand it correctly. My read is that what 1nvest is saying is that he does not hold a specific Income Reserve in cash, but that the reserve is contained within the portfolio itself. That is what I was asking about above, i.e. does an Income Reserve have to be cash.

Take two investors, twins called A and B who retire on the same day with exactly the same pension pot of £1,000,000.

A invests his entire pot in an HYP at an average forward yield of just over 7.3%, creating a forecast income of £73,171 per year. But he only needs £60,000 per year to maintain his lifestyle, so he reinvests the surplus £13,171 every year.

B decides to hold back an Income Reserve of 3 years of expenditure. His spending is exactly the same as his twin brother's, so that Income Reserve needs to be £180,000. B therefore invests the balance of £820,000 in an HYP at an average forward yield of just over 7.3%, creating an income of £60,000 per year.

B has created an HYP with an Income Reserve of 3 years spending but no Safety Margin. One way to characterise what A has done is to say he has created an HYP with a Safety Margin of £13,171 but no Income Reserve, but IMHO it could also be described as an HYP with an Income Reserve of £180,000 which has been invested.

But who has made the 'best' decision? My view is we simply do not know.

If a week after the investments have been made there is a Covid-19 style event with dividends cut and capital values falling then B is going to be in the better position because his Income Reserve is in cash and will not have been reduced in size by the fall in capital value.

However, if there is no such event for 10 years, markets rise gradually over time and there is moderate inflation then B's Income Reserve will be worth less in real terms than it was at the time the investments were made, but A's Income Reserve will likely be larger because of the capital increases, the reinvestment of his surplus £13,171 of income each year and the resulting compounding. But will it have grown enough to still be larger than B's Income Reserve after the fall in capital values associated with the Covid-19 style event? We can only guess at the answer to that question.

My view is that holding the Income Reserve in cash or reinvesting it both have pros and cons, so the decision on how to approach it will be down to each individual's own psychological make-up.

[bluedonkey]

Look, the IT "reserve" being referred to is akin to the HYP safety margin, not HYP income reserve. It's the word "reserve" being used in two different contexts. Reserve in accounting is not the same as reserve in HYP or other speak.

[Bubblesofearth]

However, if there is no such event for 10 years, markets rise gradually over time and there is moderate inflation then B's Income Reserve will be worth less in real terms than it was at the time the investments were made, but A's Income Reserve will likely be larger because of the capital increases, the reinvestment of his surplus £13,171 of income each year and the resulting compounding. But will it have grown enough to still be larger than B's Income Reserve after the fall in capital values associated with the Covid-19 style event? We can only guess at the answer to that question.

Sure, but there is still a fundamental risk difference to having some money in cash vs all in the market.

BoE

[Wizard]

Look, the IT "reserve" being referred to is akin to the HYP safety margin, not HYP income reserve. It's the word "reserve" being used in two different contexts. Reserve in accounting is not the same as reserve in HYP or other speak.

Following the mod intervention I am making no reference to ITs. I am just looking at two possible approaches.

[Wizard]

However, if there is no such event for 10 years, markets rise gradually over time and there is moderate inflation then B's Income Reserve will be worth less in real terms than it was at the time the investments were made, but A's Income Reserve will likely be larger because of the capital increases, the reinvestment of his surplus £13,171 of income each year and the resulting compounding. But will it have grown enough to still be larger than B's Income Reserve after the fall in capital values associated with the Covid-19 style event? We can only guess at the answer to that question.

Sure, but there is still a fundamental risk difference to having some money in cash vs all in the market.

BoE

Agree, it is also a risk to have an asset that is falling in value in real terms. As I say, the choice is a personal one and will be influenced by each person's view of the world.

[Arborbridge]

However, if there is no such event for 10 years, markets rise gradually over time and there is moderate inflation then B's Income Reserve will be worth less in real terms than it was at the time the investments were made, but A's Income Reserve will likely be larger because of the capital increases, the reinvestment of his surplus £13,171 of income each year and the resulting compounding. But will it have grown enough to still be larger than B's Income Reserve after the fall in capital values associated with the Covid-19 style event? We can only guess at the answer to that question.

Sure, but there is still a fundamental risk difference to having some money in cash vs all in the market.

BoE

Agree, it is also a risk to have an asset that is falling in value in real terms. As I say, the choice is a personal one and will be influenced by each person's view of the world.

I believe I mentioned this trade-off in my opening remarks. It's one which each investor needs to make for himself. I used to have a larger IR but reduced it for the reasons you mentioned, and also at one time invested some of it in ZDPs of different maturity dates which worked very well, giving me less risk than equities, but a higher return than cash.

I settled on 18 months pure cash, and the remains of what was my IR is invested in equities. Not sure whether that's a good decision or not!
Whatever we do we should consider: an IR is not much use if it isn't accessible at full value when you need it in a crisis.

Arb.

[kempiejon]

believe I mentioned this trade-off in my opening remarks. It's one which each investor needs to make for himself. I used to have a larger IR but reduced it for the reasons you mentioned, and also at one time invested some of it in ZDPs of different maturity dates which worked very well, giving me less risk than equities, but a higher return than cash.

I settled on 18 months pure cash, and the remains of what was my IR is invested in equities. Not sure whether that's a good decision or not!
Whatever we do we should consider: an IR is not much use if it isn't accessible at full value when you need it in a crisis.

Arb.

As I have said elsewhere I like the idea of 3 years of expenses and I've got most of it as cash, well premium bonds and regular savers but looking at the thread on Investment trusts and their ability to borrow, in the spirit of one of our hosts Stooz. I wonder if interest free credit cards might be another way too smooth drops over the sort term? The best interest free credit cards around offer over 2 years

[Wizard]

Sure, but there is still a fundamental risk difference to having some money in cash vs all in the market.

BoE

Agree, it is also a risk to have an asset that is falling in value in real terms. As I say, the choice is a personal one and will be influenced by each person's view of the world.

I believe I mentioned this trade-off in my opening remarks. It's one which each investor needs to make for himself. I used to have a larger IR but reduced it for the reasons you mentioned, and also at one time invested some of it in ZDPs of different maturity dates which worked very well, giving me less risk than equities, but a higher return than cash.

I settled on 18 months pure cash, and the remains of what was my IR is invested in equities. Not sure whether that's a good decision or not!
Whatever we do we should consider: an IR is not much use if it isn't accessible at full value when you need it in a crisis.

Arb.

I think splitting it makes sense. You mention "full value", a fully invested IR is unlikely to be "full value" if needed in the first year, but I suspect a wholly cash IR will not be "full value" after 10 years of inflation.

[Bubblesofearth]

Agree, it is also a risk to have an asset that is falling in value in real terms.

The way things stand just now there's every chance going forward cash will increase in value in real terms. You can already get a very good exchange rate with petrol.

BoE

[Dod101]

Agree, it is also a risk to have an asset that is falling in value in real terms. As I say, the choice is a personal one and will be influenced by each person's view of the world.

I believe I mentioned this trade-off in my opening remarks. It's one which each investor needs to make for himself. I used to have a larger IR but reduced it for the reasons you mentioned, and also at one time invested some of it in ZDPs of different maturity dates which worked very well, giving me less risk than equities, but a higher return than cash.

I settled on 18 months pure cash, and the remains of what was my IR is invested in equities. Not sure whether that's a good decision or not!
Whatever we do we should consider: an IR is not much use if it isn't accessible at full value when you need it in a crisis.

Arb.

I think splitting it makes sense. You mention "full value", a fully invested IR is unlikely to be "full value" if needed in the first year, but I suspect a wholly cash IR will not be "full value" after 10 years of inflation.

I am fortunate enough to have Index linked NSCs and they just roll up and thus ought to more or less maintain their value. They don't make them any longer though, only for existing holders.

[vrdiver]

I wonder if interest free credit cards might be another way too smooth drops over the sort term? The best interest free credit cards around offer over 2 years

They are great for Stoozing, but extremely high risk if there is any doubt about the capability to pay off in full when the interest-free period ends.

For the investor who has, say, one year of Income Reserve, if they used 0% credit cards to borrow, they might be able to extend their IR by, say, an additional 3 months, but if dividend flows don't recover enough to pay off the cards, our investor will become a forced seller.

Personally, I prefer to take the increased opportunity cost of the larger IR (in my case, 3 years cash) as I sleep more easily that way.

VRD

[Arborbridge]

Arb.

I think splitting it makes sense. You mention "full value", a fully invested IR is unlikely to be "full value" if needed in the first year, but I suspect a wholly cash IR will not be "full value" after 10 years of inflation.[/quote]

Inflation, the elephant in the room, is the reason for splitting the IR holding. My ZDPs were returning more than inflation, some regular savers were OK too, and with a multi-year recovery time, one ought not to need the IR all at once, so any sort of planned withdrawal account would work.
As a final bastion, the total IR would naturally be increased as years go by. It isn't static, but increase as one sees fit.

Arb.

[monabri]

I would urge caution regarding reserves ( or whatever you call them). I'd factor in a second wave of Covid-19 starting end Q3, start of Q4 this year. The medics ( Doctor , Matron) in my family are expecting it. You have to wonder why they are setting up mega hospitals ( 4000 bed) in the major cities. Are they just being cautious ?

I doubt this will be "mostly over" by June. I hope I'm wrong.

[tjh290633]

You have to wonder why they are setting up mega hospitals ( 4000 bed) in the major cities. Are they just being cautious ?

There would be [Deleted] and derision poured on their heads if they took no action to increase hospital capacity temporarily. ICUs are already overloaded.

Why did the Chinese have to build a temporary hospital in Wuhan? Not learning lessons has already been a criticism.

TJH

Moderator Message:
Objectionable substance removed. - Chris

[miner1000]

Agree, it is also a risk to have an asset that is falling in value in real terms. As I say, the choice is a personal one and will be influenced by each person's view of the world.

I believe I mentioned this trade-off in my opening remarks. It's one which each investor needs to make for himself. I used to have a larger IR but reduced it for the reasons you mentioned, and also at one time invested some of it in ZDPs of different maturity dates which worked very well, giving me less risk than equities, but a higher return than cash.

I settled on 18 months pure cash, and the remains of what was my IR is invested in equities. Not sure whether that's a good decision or not!
Whatever we do we should consider: an IR is not much use if it isn't accessible at full value when you need it in a crisis.

Arb.

I think splitting it makes sense. You mention "full value", a fully invested IR is unlikely to be "full value" if needed in the first year, but I suspect a wholly cash IR will not be "full value" after 10 years of inflation.

I will mention this again (although I have mentioned it many times before). I agree it is best to split your cash reserve if you can afford to. Some years ago (cant remember exactly when) I had a bit too much income reserve so I used 60% of it to buy shares in Diageo at 18 quid. Now they are twenty something several (at least 5) years later. I have subsequently rebuilt my cash reserve so all is good.

But I would only buy a really solid share (or shares) and I did not even consider the yield on Diageo when i did it. As it happens it has turned out well, but Diageo also could have gone down.
Miner

[Arborbridge]

I believe I mentioned this trade-off in my opening remarks. It's one which each investor needs to make for himself. I used to have a larger IR but reduced it for the reasons you mentioned, and also at one time invested some of it in ZDPs of different maturity dates which worked very well, giving me less risk than equities, but a higher return than cash.

I settled on 18 months pure cash, and the remains of what was my IR is invested in equities. Not sure whether that's a good decision or not!
Whatever we do we should consider: an IR is not much use if it isn't accessible at full value when you need it in a crisis.

Arb.

I think splitting it makes sense. You mention "full value", a fully invested IR is unlikely to be "full value" if needed in the first year, but I suspect a wholly cash IR will not be "full value" after 10 years of inflation.

I will mention this again (although I have mentioned it many times before). I agree it is best to split your cash reserve if you can afford to. Some years ago (cant remember exactly when) I had a bit too much income reserve so I used 60% of it to buy shares in Diageo at 18 quid. Now they are twenty something several (at least 5) years later. I have subsequently rebuilt my cash reserve so all is good.

But I would only buy a really solid share (or shares) and I did not even consider the yield on Diageo when i did it. As it happens it has turned out well, but Diageo also could have gone down.
Miner

One of the OEICS I invested in for part of my "near cash" part was Invesco Perpetual Monthly Income plus. OT for this board, except I mention it as a possible receiver for "more risk than cash, but less risk than full equity investment". Despite the income being more or less constant, the XIRR has been over 10% since 2010 - surprisingly good - and I've been perfectly happy to keep it on espescially in the current crisis. I had intended to liquidate it and buy equities, but I think it'll stay there as a core backstop.

As I say OT, so no extended discussion asked for. I just thought it worth mentioning in the context of income resevoirs. I'm sure people have there own ideas in this area and I'm not saying this is the best.

Arb.

[1nvest]

I draw my own 'dividends' to my own level and timing out of total returns using yearly capital gains tax allowance and tax harvesting practices.

I think there are some elements of this post that are worth considering, if I understand it correctly. My read is that what 1nvest is saying is that he does not hold a specific Income Reserve in cash, but that the reserve is contained within the portfolio itself. That is what I was asking about above, i.e. does an Income Reserve have to be cash.

2% dividend is no different to taking 2% out of total return. Historically withdrawing a initial 2% amount, and then uplifting that £ capital amount by inflation each year and drawing that amount (Safe Withdrawal Rate (SWR)) in subsequent years had very high probability of success whilst providing a assured income in inflation adjusted terms. Dividends in contrast can rise and fall in real terms - provide less consistent inflation adjusted income.

Fundamentally dividends are a costs/taxable event generation regime that are a service to stock/currency brokers, market makers and the tax man/a disservice to their investors. Amounts paid out that fit none of their investors well. Too much for some, such that they reinvest, too little for others, inappropriate times for yet others. If no stocks paid dividends but instead used what would have been paid in dividends to repurchase some of their own shares (or even used the amount to buy shares in a index fund that they managed) then each individual investor can fine tune the amount and timing of their own 'dividends' - by selling some shares.

3% SWR was also historically safe. It used to be that 4% was also considered safe but some now question that. 5% SWR and above and it becomes more of a coin flip. As you say the cash reserve is in the portfolio, you could hold that 'cash' in a separate account and manage the two accounts being invested in the exact same portfolio/asset allocation rather than having one invested in cash deposit accounts/wherever. Or rather than a 3% SWR solely taken from stock you might initially drop 15% of the total portfolio value into a cash deposit account and use a lower 1.75% SWR against the remainder 85% stock invested portfolio value (1.5% relative to the whole), and top the remainder of a total 3% SWR withdrawal amount up from the cash account - where that original 15% of portfolio value deposited into cash draws down to zero over 10 years. If you also top slice real gains from the stock portfolio when it is up to top up that cash account then that's like taking multiple years of partial dividend amounts out into cash when stock valuations/prices were up/high. If the cash account is relatively rich then in some years such as when stocks were down you may opt to not draw any SWR from stock and instead take it all from the cash account.

So no, the cash reserve doesn't have to be in cash, could even be all invested in stock, or in a stock/cash combination, or whatever. Drawing a SWR when the stock portfolio value is down is a bad action as you have to sell more shares to generate the same amount of cash proceeds - but that's no different to a stock paying dividends when share prices are down. Having some in cash can help avoid having to withdraw from stocks when stocks are down. If on average you're withdrawing 1.5% from stock, 1.5% from cash to generate a 3% SWR then that's like having 'cash' invested 50/50 stock/cash.

[Arborbridge]

So no, the cash reserve doesn't have to be in cash, could even be all invested in stock, or in a stock/cash combination, or whatever. Drawing a SWR when the stock portfolio value is down is a bad action as you have to sell more shares to generate the same amount of cash proceeds - but that's no different to a stock paying dividends when share prices are down. Having some in cash can help avoid having to withdraw from stocks when stocks are down. If on average you're withdrawing 1.5% from stock, 1.5% from cash to generate a 3% SWR then that's like having 'cash' invested 50/50 stock/cash.

The paragraph starts off by asserting one does not need a cash IR, but ends up saying one does because it alleviates selling when prices are down.

Quite so, that's why we have an IR QED.

Arb.

[Itsallaguess]

Fundamentally dividends are a costs/taxable event generation regime that are a service to stock/currency brokers, market makers and the tax man/a disservice to their investors.

Amounts paid out that fit none of their investors well.

Too much for some, such that they reinvest, too little for others, inappropriate times for yet others.

I'm sorry, but fundamentally, that all sounds like a load of old cobblers in my opinion..

I can't see a single valid statement in the above that will be relevant in a negative way to the vast majority of income-investors, or at the very least aren't as equally 'negative' for any type of investor....

Cheers,

Itsallaguess

[Dod101]

This whole thread has degenerated into gobbledegook. I have no idea what 1nvest is on about and frankly the idea that an income reserve or whatever name you care to give it can be invested as part of a portfolio is surely a contradiction in terms. The whole point of a cash or income reserve is that if the portfolio drops as it has just done, the reserve is there unscathed by what has happened in the market. It therefore needs to be in cash or a cash equivalent.

So the title of the thread is no longer valid.

Dod