Recently on the morning news it was reported that a South Carolina man got really lucky. He bought several $10 lottery scratchers and won $200,000, not once, but twice in the same week. When asked what he was going to do with his money, he responded, “With the first $200,000, I’m going to fund my children’s college education and put some away for an emergency”. When he won the second time, he responded with, “The second $200,000 is going towards my retirement.” Lucky man and excellent plan!
If you haven’t been as lucky as this gentleman, you’re going to have to work a bit harder to build an effective retirement or education plan. To help you in that effort, there is a strategy we can suggest, The Power of Three, a strategy of allocating funds into different buckets with different investment strategies to provide flexibility, a greater ability to save, and a structure to help you reach your financial goals.
Over the past several years, our planning clients have asked how they can maximize their spare cash or short term savings given the current low interest rate environment and what they should do to provide greater flexibility in the event of a financial emergency. By planning ahead and starting early, you can create two distinct types of short term savings accounts to help create added flexibility: (1) an Emergency Reserves bucket; and (2) an Excess Cash Reserves bucket. This two bucket combo is designed to protect your retirement accounts or long-term money in the event you need cash quickly. The idea is that you pull from your short-term funds before you pull from your long-term funds. In general, investment strategies for short-term money are more conservative and less prone to volatility. Longer term investments are generally invested more aggressively and can be negatively affected in the short term by market fluctuations.
The Power of Three strategy positions you with three types of cash or investment buckets: (1) an Emergency Reserves bucket, (2) an Excess Cash Reserves bucket and, (3) longer term retirement accounts. Each of these buckets of funds should be invested based on your own time horizon, risk, and return needs. This simple, but effective, technique can allow you the flexibility and power to weather short term downturns in the market and/or emergency cash needs while keeping your longer term investments where they should
be — in your retirement account.
The mechanics of The Power of Three are straight forward:
Step #1: Emergency Reserves
Allocate cash into an account designed for emergencies and unexpected events such as a job loss, need for a new roof, or auto accident — really anything that must be dealt with immediately to protect your family or work situation. First bucket investment strategy: Use a savings account, preferably high yield, fully liquid, and quickly accessible. We generally advise our clients to target an amount between six and twelve months of living expenses.
Step #2: Excess Cash Reserves
Allocate cash to a second account, the goal of which is to beat inflation without being exposed to the risks of the stock market. Second bucket investment strategy: Given the safety of the first bucket, one can generally take a bit more risk with this second bucket, and we usually advocate investing in fixed income securities — bonds of short to intermediate term duration and maturity. We advise our clients to target an amount between one to two years of living expenses for this bucket.
Step #3: Long-Term Savings
Make monthly distributions to your retirement or educational savings accounts from your salary or other income to ensure you are saving toward these goals. Studies show monthly automatic savings contributions are one of the best means of making sure those savings dollars are going where they should be going. Investment strategy: There isn’t space here to go through all the different investment strategies available for retirement and educational savings accounts, but your longer term tax-deferred savings should be invested on a more long-term basis, with your own individual time horizon, risk, and return needs in mind.
In summary, The Power of Three allows you to: 1) protect yourself in a financial emergency, 2) put excess cash reserves beyond your emergency reserves to work to keep pace with inflation, and 3) implement an effective strategy to build your retirement or educational savings account/s. By implementing this strategy, you are better able to weather both bond market and stock market fluctuations and volatility.
You can learn more about maximizing cash reserves by watching this short video:
For more information, check out the full video of our recent webinar, “Financial Planning for Boomers”, in which we talk more about this strategy and others that may be of interest to you.
Invest well and attain peace of mind!