By definition, trauma leaves a scar. Fifteen years after the bursting of the tech bubble and more than eight years after the advent of the last financial crisis, many investors are still being impacted by the memory of those traumatic events.
As a result, a sizeable portion of U.S. households are placing a disproportionate amount of their savings in cash.
While this is understandable, and in the short term even prudent, it comes with an enormous cost: With cash yields likely to remain low for the foreseeable future, many families will likely struggle to fund an increasingly elongated retirement.
The recent BlackRock Global Investor Pulse Survey of more than 4,000 Americans illustrates the significance of the problem. Nearly 4 in 10 people surveyed expressed a need to save cash to act as a “security blanket” for any emergencies.
The extra cash that households are stashing away is coming at the expense of longer-term savings or investments. Less than a quarter of those surveyed systematically put aside money for long-term savings or an investment plan. Particularly troubling, many younger Americans, those aged 25 to 34, agreed that “what you might earn investing isn’t worth the risk of losing money.”
Based on the survey results, it seems that many Americans are aware that their current saving and investment strategy may be inadequate. Unfortunately, the respondents seemed unaware of just how large the gap between savings and desired retirement income may be.
Those aged 55 to 64 expected to have a $45,500 annual income in retirement. At current levels, using BlackRock’s CORI Index, their savings would produce an income stream of roughly $9,000/year, a fifth of their desired income level. And while it’s true that more affluent investors, defined as those earning more than $250,000/year, are closer to their retirement income goals than others, even among this group, there was still a sizable gap.
One reason for the gap is simply under saving. Stagnant real wage growth has left many families unable to save for the long term, even when they recognize the necessity. However, another contributing factor is excess conservatism, itself a lingering aftershock of the financial crisis.
Reuters/Mushtaq MuhammadA man counts wads of U.S. dollars on a money counting machine at a currency exchange shop in Kerbala, 80 km (50 miles) southwest of Baghdad, Iraq.
Unfortunately, in a world in which cash pays next to nothing and even riskier assets, like stocks and bonds, have a lower long-term expected return than they once did (according to a BlackRock analysis using Bloomberg data), holding a sizeable portion of one’s retirement savings in cash could prevent many from reaching their financial goals. A simple illustration brings home the point.
Consider eight hypothetical portfolios. The first is a simple blend of 60 percent U.S. stocks and 40 percent U.S. bonds. Each successive portfolio lowers the allocation to stocks and bonds by 5 percent and raises the allocation to cash by 10 percent.
In addition, let’s assume hypothetical expected returns for U.S. equities, Treasuries and cash of 4.4 percent, 1.6 percent and 1.2 percent respectively, using BlackRock Client Solutions’ five-year return assumptions for various assets.
As the accompanying chart illustrates, as the percentage allocated to cash rises, hypothetical expected portfolio returns fall. When you go from 0 percent cash to 70 percent cash, the expected annual portfolio return falls by over a third, from 3.28 percent to barely 2 percent.
While none of these portfolios is likely to produce particularly inspiring returns—a function of already elevated valuations for both U.S. stocks and bond—the difference between the two extremes is still important.
ssuming an initial investment of $100,000, over a 40-year horizon, that 1.2 percent difference in returns translates into an over $140,000 difference ($363,000 for the portfolio with no cash vs. $222,000 for the portfolio with the most cash).
For many retirees, this kind of gap represents the difference between a comfortable retirement and a serious financial problem.
Read the original article on The BlackRock Blog. Copyright 2015. Follow The BlackRock Blog on Twitter.