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This article appeared in the March 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Sacrificing some yield to reduce risk is worthwhile for people in or approaching retirement.

Photo of Nerida Cole By Nerida Cole, Dixon Advisory

The latest reduction in Australia's official interest rate presents another challenge to investors already dealing with an extended period of global market volatility.

The attractive yields on offer in Australian shares are tempting but the risks of overdoing the exposure to volatile growth assets include a catastrophic deterioration of capital in the event of a correction or downturn.

Apart from diversification, cash - specifically government-guaranteed cash accounts - provides a significant liquidity advantage over almost all other asset classes.

Understanding your needs and making a strategic assessment of your income sources, regular expenses and lump-sum requirements, are key steps to helping set an appropriate balance of cash for your portfolio.

Why hold cash?

Cash forms part of the defensive side of an investment portfolio, diversifying against some of the disadvantages associated with growth assets, particularly volatility and risk of capital loss. This is particularly important for people in or approaching retirement, because a correction or loss during the "retirement risk zone", the years immediately before and after retirement, can destroy decades of saving.

Because portfolio sizes generally reach their peak at retirement, the effect of a negative return will be more significant and difficult to recover from compared to the same downturn occurring earlier in your lifetime when the portfolio was a smaller size.

Take, for example, a couple who have built up a $1-million investment portfolio through a lifetime of disciplined saving, hard work and careful planning. A 20 per cent loss due to a market downturn close to retirement would see a $200,000 loss and leave $800,000 for retirement.

This would probably result in a very different retirement lifestyle than planned. If this shock occurred earlier in life at a time when $100,000 of savings was at risk, only $20,000 would be lost.

Investors near the retirement stage generally need to draw income from their portfolio to cover living expenses and for lumpy costs such as a car or a child's wedding. Wealth-builder investors are more likely to require cash for servicing borrowings, repairs and maintenance, and school fees.

Selling equities or other assets to provide cash flow is risky and can result in selling at a reduced price, thereby requiring the sale of more units to free up the same level of cash.

This sharply reduces the longevity of a portfolio. Assets such as property may take several years to realise, requiring other investments to be sold in the interim to provide the required cash.

Taking a dynamic approach to asset allocation allows investors to take account of short-term expenditure and regular income needs, and employ unallocated capital to asset classes with growth prospects aligned to appetite for risk.

With high dividend yields on offer from Australian equities, some investors hope the dividends will provide enough cash flow to meet their needs. However, dividends are not guaranteed and if a portfolio has insufficient liquidity to meet living expenses or an unexpected emergency, selling assets can be a costly back-up plan.

What to consider in calculating cash allocations

Retirees should allow a cash allocation in their portfolio that covers lumpy expenditure items that will arise in the next two years. A further three years' worth (approximately) of their planned pension payments should be held to protect the fund's ability to make minimum payments. If the minimum payment is not made due to insufficient liquidity, the tax benefits of being in the pension phase are removed.

Investors in the wealth-building phase who have income from employment to cover day-to-day expenses and capital lump sums, should still allow a sufficient allocation to cash to cover at least one year's worth of the minimum loan payments on all debt held. This can assist to buy time and avoid a firesale of assets should a tightening in remuneration, job loss or economic downturn occur.

Even without debt or an active investment strategy in place, cash provides an important safety net to cover unanticipated expenses such as a medical emergency, without needing to realise investments. At least three months of living expenses in cash to cover unanticipated expenses is a good rule of thumb.

Giving up some yield can be difficult, but investors should also remember holding good cash levels can make it possible to take advantage of new investment opportunities. Value investors may at times hold larger allocations to cash as they wait for valuations on favoured equities to move below their true value. When the well-researched equities fall below their price target, they move into the market.

How and where to hold cash

It is important to consider how and where your cash is held so the liquidity advantage is not trapped by tax, legislative restrictions or redemption delays.

Unless you have reached superannuation preservation age (ranging from 55 to 60 years depending on date of birth) generally access to superannuation is restricted. After you reach preservation age, superannuation legislation permits up to 10 per cent of the pension account balance to be drawn on an annual basis until retirement is declared, or you reach age 65, at which point the maximum withdrawal limit is removed. Tax may still apply until the age of 60, when super becomes entirely tax-free.

Therefore, splitting the overall cash allocations between super and non-super portfolios will need to take into consideration the timing of capital expenditure. For younger wealth builders it is not uncommon for the majority of cash to be held outside the super environment.

Investors would also be wise to look in the underlying investments that make up the cash account they are investing in. Some funds employ sophisticated "cash-like" investments in an effort to pump up yields. The returns tend to be more volatile and the asset does not offer the same level of capital security associated with traditional bank cash accounts.

True cash, as exemplified by government-guaranteed accounts, offer security and immediate access. SMSF trustees have access to these accounts, as do individuals investing in their personal name.

With careful planning, holding enough cash can help the growth side of your portfolio ride out market fluctuations; and provide a source of cash flow to top up living expenses and capital expenditure, reducing the likelihood of a forced sale of investments.

About the author

Nerida Cole is Managing Director, Financial Advisory, Dixon Advisory.

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