YMOYL Chapter 9, Part 3: Capital, Cushion and Cache

Reminder! Casual Kitchen is running an in-depth, chapter by chapter review and analysis of the book Your Money Or Your Life throughout the month of January. Join us! You can buy YMOYL here, and you can find the first post in the series here.

We'll return to our more typical food and health-related content later in February. As always, thank you for your time and attention as we re-run this series!

This week, we'll finally (finally!) tie up the last few loose ends of Chapter 9 with an analysis of Capital, Cushion and Cache. First a quick review:

* Capital is the primary nest egg that you'll use to generate investment income. This income will supplement--and eventually replace--your work income.
* Cushion is a separate account that contains a minimum six month cash reserve.
* Cache is a source of still more investment capital--beyond Capital and Cushion--that provides yet another layer of financial protection.

We've already discussed Capital, so we won't spend time on it here. After all, if you've been diligently following the YMOYL process like you should, then you've been tracking and aggressively adding to your Capital since Chapters 3 and 4.

Your Cushion is essentially a garden-variety emergency fund. Everybody should have an emergency fund. This is an elementary concept of personal finance. The question isn't whether to have one, the question is how many months' worth of expenses should I hold?

YMOYL's authors (as well as many personal finance experts) recommend six months. Laura and I keep one full year of expenses in our Cushion. For some, perhaps 18 or even 24 months might be appropriate. You'll have to decide what's right for you given the nature of your work, the reliability of your income, and what resonates with your personal sense of financial safety. I'd argue that six months of expenses is an absolute minimum, nine months is better and--for us, at least--twelve months is optimal.

It's probably best to keep your Cushion completely separate from your regular bank account, especially if you have a tendency to spend money that's too easy to get at. You may even want to set down, in writing, a list of clear and strict rules for when you would use this money. What kinds of emergencies is it for, specifically? Under what circumstances will you tap into this account?

Yes, I know. We've all sworn off gazingus pins by now. Still, it's only sensible to make it extra, extra difficult to spend your Cushion on something it was never intended for.

Finally, think about the tradeoffs you make by having a big versus a small emergency fund. Are you sacrificing money that could be prudently invested in your Capital account, earning passive income? Or is the peace of mind from having twelve (or more) months of cash sitting safely somewhere worth more than a small amount of foregone investment income? As always, it's up to you to decide, and there are no hard and fast rules here. But please remember: most people do not have emergency funds at all. You have a high-class problem just by virtue of the fact that you're deciding how big yours should be.

Now, onto Cache: First, a caveat: Cache is something you'll focus on much more after you reach the Crossover Point. If you're only just beginning your road to financial independence, don't worry about this concept yet. Just keep your head down, keep managing your Wall Chart and keep making income-generating investments.

Second, the authors do a suckola job describing the concept of Cache--no surprise given all the other problems with Chapter 9. It's almost funny how the book briefly introduces the idea on page 271, then drops it, and then randomly picks it up again twenty pages later. It's a sad oversight, because the concept is extremely useful.

Hmmm. I guess that's why I'm writing this series.

Here's how to think about Cache. Imagine yourself in your post-Crossover Point life. You're not working (or at least you're in a financial position where you don't need to work), and you're funding your expenses with income-generating investments in your Capital account. Sounds pretty good, doesn't it?

Well, unless you spontaneously forget all the principles of YMOYL, you'll still be living within your means after you've reached the Crossover Point. You'll still want to be sure your spending decisions are appropriate expenditures of your life energy.

Moreover, once you leave full time work, your monthly expenses are likely to go lower--possibly much lower. Remember all of those disturbingly high job-related costs you listed back in Chapter 2? Buh-bye.

There's more: it's highly plausible that you'll earn some side income from time to time. Maybe you'll start up a high-traffic food blog that earns you a few hundred bucks a month (*cough*). Maybe you'll do some consulting in your spare time for a local business. Maybe you'll learn a new profession and take on some part-time work just for fun.

Finally, you might on occasion receive windfalls like a bigger-than-expected tax refund. Remember, the tax code treats most forms of passive income far more favorably than regular salary income, so your post-Crossover Point tax expenses are likely to decline too.

All of this suggests you'll most likely continue to save and accumulate money even after you've stopped working. This money's gonna add up, and it's going to generate still more passive income. That's your Cache. That's why you don't need to worry unnecessarily about longer term issues like inflation, and that's how you'll protect yourself from any unexpected big-ticket expenses. You've inoculated yourself against these risks with extra Cache.

The bottom line: You are likely to have higher income and lower expenses than you expect once you reach your Crossover Point. Simply add that money to your financial resources, put it to work, and you'll have yet another layer of financial security.

Structuring your Capital, Cushion and Cache accounts
I'll close this week's post with some thoughts on different ways you can structure your Capital, Cushion and Cache accounts. As with most things, simple tends to be superior, so with that in mind I'll share a laughably simple model you can consider for your finances:

* A checking account to pay monthly expenses,
* A savings account to hold your Cushion/Emergency Fund,
* A brokerage account, containing your income-generating Capital,
* A separate brokerage account, where you can put any additional Cache.

I'm often asked what I think about IRAs and 401(k) accounts, or purpose-specific accounts like educational IRAs. My stock response is to tell people to take advantage of the things they want to take advantage of. If your company provides a generous 401(k) match, by all means take it. If you think setting up a separate educational IRA will really help you fund your kids' education, go for it. Do what works.

But my general view is complexity is the enemy. You will have only so much bandwidth to manage so many accounts. So it's probably best to keep things simple: keep a minimum of accounts and try to make the bulk of your income-generating investments in one primary investment account.

One final thought for readers regarding IRAs, Roth IRAs and 401(k)s. Don't get me wrong: these standard retirement account types have their advantages. However, recognize that by following this book, you are embracing a highly non-standard approach towards retirement. Depending on your age and how diligently you follow the YMOYL process, you may very well reach your Crossover Point years before you can enjoy penalty-free access to assets sitting in these standard retirement accounts.

Keep this in the front of your mind as you allocate and invest your Capital.

Appendix/Side Thoughts:
1) On the concept of enough: Readers, what is "enough" to you? I've seen estimates that Joe Dominguez reached his personal Crossover Point on a $300,000 investment portfolio. For him, three hundred grand was "enough." And if any of you have ever read Early Retirement Extreme (I've periodically linked to it in my Friday Links posts), that blog's author, Jacob, reached his crossover point on just $150,000.

Jacob's and Joe's ideas of "enough" may seem laughably low to you. But then again, I know people from my former career who don't feel they have "enough" even though they're sitting on nest eggs in the double-digit millions. If anything, this is just proof that the principles of Your Money Or Your Life can be effective across a truly vast range of income and net worth levels. But the principles will only work if you're willing to make them work.

2) The various personal anecdotes in Chapter 9 are worth rereading: Every reader will find something to identify with, or an example to learn from, in each of the anecdotes in the Chapter 9. Everyone has different ways of processing the emotions, risks and personal issues that emerge at each of the various stages of enlightenment with money.

"Rosemary," for example, recognized that she's ultra-conservative with money, so she chose to keep extra Cushion in place to assuage her concerns. "Clair and Mike" are going to have a real problem when their existing Treasury bonds mature--they will face the same reinvestment risk we discussed two posts ago. "Carl" postponed leaving work until he learned to be more self-sufficient around the home. After all, he didn't want to waste life energy paying others for things he could do himself. "Ted and Martha" created an itemized list of every long-term liability they could think of and inoculated each expense with long term bond investments. "Alan and Tricia" took the most idiosyncratic path of all: they returned to work and then became FI all over again. And so on. There's an unlimited number of ways to walk the path of YMOYL.

3) For further reading on Cushion and Cache: Let me recommend yet another book I found extremely useful (despite its get-rich-quick-sounding title): The Buckets of Money Retirement Solution by Ray Lucia. This book teaches a surprisingly elegant system of setting out various buckets (or Caches, if you will) of capital to meet all of your financial needs. Very much worth a read.

4) Yes-butting and you: Note the quote on page 277 that says Watch out for those "Yes, but..." conversations in your head. Oh, how that warms my heart. I think I can say with total confidence that no one reading this series will allow themselves to get sucked into a yes-but conversation. Not on my watch.

5) Finally, some gratitude: It's vaguely embarrassing that it took me three posts to cover Chapter 9. But there's a lot to discuss here, including plenty of material that should be in this chapter but regrettably isn't. I'm grateful for my regular readers' patience with this series, and even more grateful to see so many new readers visiting these posts here at CK... despite their length. As always, thank you for your attention and interest.

Coming Up! Becoming a Sophisticated Investor: Six Steps

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Unknown said...

I do struggle with some of the concepts presented.

I think there is a lack of emphasis on inflation, as well as an over-emphasis on how much income can be produced.

You mention "it's highly plausible" to earn side income to protect against inflation. In reality, this approach would require it, and in large amounts.

Say your annual expenses are $30k. After just 10 years of 2% inflation, that $30k has a current dollar purchasing power of $24.5K. After 20 years, $20k. That's massive.

So part of the issue is that. Another part is that there is an underlying assumption that you will leave your entire savings as a legacy.

This also ties in to my disagreement with a previous post re: not caring if a dividend paying stock price goes up or down. You will likely need to consume principal.

Last, the comment re: "you may very well reach your Crossover Point years before you can enjoy penalty-free access to assets sitting in these standard retirement accounts" is not wholly accurate given IRS Code 72(t) for those 35 years of age or older.

Daniel said...

Thanks NGN for another excellent comment.

I think it's worth considering inflation as a risk, so it's excellent that you're doing so. If you consider it a major concern there are additional steps you can take before quitting full time work (e.g., wait until you have more margin for error between your expense line and your investment income for example, make sure you have extra-EXTRA cushion and cache, or make sure you have already budgeted a meaningful post retirement savings rate). At the end of the day, however, all of these solutions revolve around a simple primary solution: save more money. I wish I had something more palliative to say than that. :)

Finally, I didn't quite understand the thrust of your last comment about retirement accounts.


Unknown said...

IRS Code 72(t) allows those over 35 but younger than 59 1/2 to withdraw from tax deferred accounts penalty free.

Daniel said...

Thank you for sharing your insights NGN!