Welcome back, TJA friends! Douglas here with another reader question. Let’s get into it.
QUESTION:
We’ve built a strong cash reserve but heard interest rates are coming down later this year. Is there anything we can do to keep our savings earning a high yield?
ANSWER:
If you know me, you know how much I love having a deep cash reserve. I am not talking about a generic “three-to-six months of living expenses” reserve. As a millennial who entered the workforce at the start of The Great Recession and raised little kids through a global pandemic, I want to feel like Scrooge McDuck when he jumps into a giant vault of coins. For me, that’s a six-to-nine-month cash reserve. It’s a conservative choice but one that eases our anxieties from the past and accounts for our realities of today, now that Heather’s joined the firm and we don’t have the security of her corporate paycheck.
There’s never been a better time to maintain a strong cash reserve. Gone are the days of receiving 0.01 percent in your savings account. Over the past year, savvy savers have been rewarded with risk-free interest rates of around five percent. You’d need to go all the way back to 2007 to get that type of yield on your cash!
But of course, nothing lasts forever. The Federal Reserve is signaling a rate cut will take place later this year–and the market indicates that may happen as early as September. I wouldn’t anticipate a dramatic slice and dice, but every point counts, so it’s worth reevaluating your plan.
Many financial advisors like to use a tiered system for managing cash reserves. This means, we don’t just put a client’s entire reserve in a savings account and call it a day. Instead, we divided reserves across multiple types of cash instruments, such as: high-yield savings accounts; money market funds; certificates of deposit; and treasury bills. We do this to maximize yields for as long as possible while making sure clients have access to their money. Here’s an example of how this works.
Sam and Sara are in a good financial position and have established a nine-month cash reserve of $60,000, which currently sits in their checking account and a high-yield savings account earning five percent interest. Not bad, but like our reader, they know that the five-percent rate in their high-yield savings account is fleeting. So, to improve their situation, they can divide their reserves into three tiers (we’ll divide equally to make things super easy in this example).
For the first tier of their reserve, they will keep $20,000 in their checking account, so they have money readily available to pay their bills and grab some cash from the ATM when needed. Unfortunately, most checking accounts don’t earn much in interest, but that’s okay, since they will actively use that cash to handle their financial lives. Again, I split their reserves into equal parts; but in reality, you want to keep an amount in your checking account that covers a month’s worth of expenses plus some additional cash in case you run a little hot.
The second tier of their reserve utilizes a high-yield savings account or a money market fund. Both instruments offer yields linked to where interest rates are today and allow for quick and easy access to cash. It generally takes a day or two to move money from either instrument to your checking account or your brokerage’s cash account. So, even though yields will fall when rates are cut, it’s prudent to have a portion of their reserve positioned here.
Now, this is where things get interesting. For the third tier of their reserve, Sam and Sara are going to use certificates of deposit (CDs) or Treasury Bills (T-Bills) to create something called a ladder. A ladder is a strategy that involves using multiple CDs or T-Bills with different maturity dates. This allows them to lock in today’s interest rates for a specific period of time. And since the ladder ends up maturing on a rotating basis (see example below), it gives them the ability to renew a CD or T-Bill at higher rates while providing them regular and penalty-free access to their cash.
$20,000 CD Ladder Example:
$5,000 in a 6 month CD @ 5.1% → Renews as a 24 month CD
$5,000 in a 12 month CD @ 5.2% → Renews as a 24 month CD
$5,000 in a 18 month CD @ 5.3% → Renews as a 24 month CD
$5,000 in a 24 month CD @ 5.4% → Renews as a 24 month CD
*One CD will mature every six months.
Managing your cash reserves is crucial, because you should have your cash working as hard as possible for you. And there’s a lot of room in these strategies to personalize them based on your risk tolerance as a couple. Partners with more confidence might favor a larger and longer ladder, while others might position more of their reserves in a high-yield savings account. You do you, but do something.
Just note, while earning a decent yield is awesome, holding cash this way isn’t a substitute for investing and how it can grow your wealth. In a prior newsletter, we discussed the potential for missed opportunities when one partner actually wants to live like Scrooge McDuck on a giant mound of cash. Go back and re-read that Q&A with this one!
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The content shared in The Joint Account does not constitute financial, legal, or any other professional advice. Readers should consult with their respective professionals for specific advice tailored to their situation.
