For Financial Advisers only
CASH RESERVE
STRATEGY
AREAS TO CONSIDER
The main aim of using a cash reserve strategy is to avoid ‘pound cost ravaging’ by avoiding selling units from the invested portfolio when
markets have fallen. However this strategy does also create some difficult questions:
1. How much should be held in the ‘cash bucket’?
• Most strategies advocate holding somewhere between one and five years’ worth of income. What is the right number?
•Too few and the client could be forced to top up the cash bucket when markets have fallen, exacerbating the problem rather than
solving it.
• Too many, and there will be significant compounding effects of charges/low interest rates/inflation on the cash bucket.
•To compensate for this, bear in mind that an additional amount may have to be held in cash to cover charges and protect against
inflation.
2. When should the ‘cash bucket’ be topped up?
• If this is at annual review, what if markets have just fallen?
•If this is facilitated by an automatic process, such as a platform rebalance, there similarly is no consideration as to whether markets
have just fallen when this occurs.
•The alternative is to manually ensure, on a client-by-client basis, that the bucket is topped up in favourable conditions (i.e. when markets
have risen).
• Consideration should be given to the administrative issues this might cause when dealing with large numbers of clients.
3. What is the long-term effect of ‘cash drag’ on an investment portfolio?
•Over the long term markets are generally up more than they are down. Therefore in many cases a cash reserve strategy may provide a
less favourable outcome as the cash element will have a negative impact on the long term return of the portfolio.
• Obviously, this will also have an undesirable effect on the longevity of the income that the portfolio produces.
•An alternative investment strategy for the invested element of the portfolio could be considered, but this will cause additional volatility,
which may not fit the client’s risk appetite.
CASH RESERVE STRATEGY – EXAMPLE CALCULATION
• In the example below, we have assumed that the client requires a 5% income based on their initial investment of £100,000.
• They aim to hold three years’ income in cash.
• We have also allowed for inflation on the cash at 2%, and charges (0.4% platform plus 0.75% adviser charge) totalling 1.15%.
• To achieve this, the portfolio would need to achieve a return of 26% in three years or 7.8% compound net of portfolio OCF.
• This is unlikely to be achieved.
1.
2.
Initial investment
£100,000
Year 1
Year 2
Year 3
Income
£5,000
£5,000
£5,000
Charges
1.15%
1.15%
1.15%
Inflation
2.00%
2.00%
2.00%
Total charges £
£157.50
£157.50
£157.50
Total to disinvest
£5,158
£5,158
£5,158
£15,4741
Account value
CRA value
CRA value
CRA value
Initial CRA value net of CRS
£102,000.00
£104,040.00
£106,120.80
£84,5262
Total cash reserve for three years
Account value after cash reserve strategy
Total sold for 3 years CRS
ACADEMIC OPINION ON CASH RESERVE STRATEGY
•Probably the most extensive study conducted on cash reserve strategy was undertaken by two American academics, Walter Woerheide
and David Nanigan.
•They looked at using a cash reserve strategy holding one, two, three, and four years income and compared it against fully invested
portfolios.
• The data looked at a variety of withdrawal rates and asset allocations.
• It was tested against 83 years of historical data.
•The assumption was made that when markets were up, income was taken from the invested portfolio, and when markets were down, it
was taken from the cash reserve.
• The conclusion was that in more than 80% of cases, the cash reserve strategy had a negative impact on portfolio longevity.
CONCLUSION
The conclusion is that holding cash can, in a minority of circumstances, help protect against sequence of returns risk in the initial years of
decumulation. However the cash element can provide a drag which has a negative long term impact on the portfolio. The answer therefore
would seem to be having a dynamic policy, increasing cash weightings at the onset of periods of market volatility to reduce pound cost
ravaging, and decreasing it during periods of steady growth to enhance investment returns. However, this is a difficult strategy to manage, as
the anticipation of market volatility requires a high degree of investment skill; and there are significant challenges to implementing this strategy
with a large number of clients.
GENERATION: A DECUMULATION INVESTMENT SOLUTION
The Old Mutual Generation funds are run specifically for retirement income clients and are managed with a ‘decumulation mindset’,
i.e. an anticipation that investors may need access to capital, regardless of whether markets have just fallen or not. The Generation funds
have a dynamic asset allocation policy, using cash as a defensive cushioning strategy during volatile periods while maintaining an allocation
to real assets designed to provide sustainable, inflation (CPI) plus returns.
Generation can be used either as a standalone decumulation solution, or as part of a strategy to replace the cash reserve alongside an
accumulation portfolio. If used in either latter strategy, it may help to eliminate many of the issues that CRS can cause:
1. It aims to produce an inflation plus return after charges
2. It is actively managed to cushion short term volatility
3. It removes the onus on the adviser to find an appropriate point to top up a ‘cash bucket’.
Past performance is no guarantee of future performance and your client may get back less than they invested.
www.oldmutualwealth.co.uk
Calls may be monitored and recorded for training purposes and to avoid misunderstandings.
Old Mutual Wealth is the trading name of Old Mutual Wealth Limited which provides an Individual Savings Account (ISA) and Collective Investment Account (CIA)
and Old Mutual Wealth Life & Pensions Limited which provides a Collective Retirement Account (CRA) and Collective Investment Bond (CIB). Old Mutual Wealth
Limited and Old Mutual Wealth Life & Pensions Limited are registered in England and Wales under numbers 1680071 and 4163431 respectively.
Registered Office at Old Mutual House, Portland Terrace, Southampton SO14 7EJ, United Kingdom.
Old Mutual Wealth Limited is authorised and regulated by the Financial Conduct Authority. Old Mutual Wealth Life & Pensions Limited is authorised by the Prudential
Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Their Financial Services register numbers are 165359
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SK12783/216-0650/June 2016