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How Savings Protect Your Investments

How Savings Protect Your Investments

April 30, 2019

How Savings Protect Your Investments

LFG Marketing | May 2019

Want to improve your chances for long-term financial success? You might want to focus on maintaining healthy cash reserves.

Recent studies suggest one of the reasons many Americans struggle to accumulate enough to retire is because they don’t take a “protection-first” approach by establishing a foundation of cash reserves.

A 2017 working paper* from the Harvard School of Business, co-authored by six professors from various disciplines, found that the lack of cash reserves – secure, liquid savings available for unexpected financial events – was one of the biggest deterrents to successful long-term accumulation.

Because of inadequate cash reserves, many households end up tapping the balances in their long-term accumulation accounts, particularly their employer-sponsored 401(k)s.

These early withdrawals hurt long-term accumulation in several ways:

  • Pre-retirement withdrawals not only reduce the account balance, but also forfeit the earnings or appreciation that could accrue if these funds remained invested.
  • Early withdrawals often incur additional costs in the form of tax penalties or loan repayments.
  • Many retirement accounts are invested in assets whose values fluctuate daily. Early withdrawals may mean liquidating investments at inopportune times, possibly at a loss (or selling strongly-performing assets and ending their potential for above-average gain).

This “leakage” from retirement accounts is significant. The Harvard report noted that in the past decade approximately one in seven taxpayers under the age of 55 made taxable withdrawals from retirement plans in any given year. Over the same period, data from the Federal Reserve and Internal Revenue Service estimated that between 30 and 40 cents of every dollar deposited into retirement accounts by participants under the age of 55 had been withdrawn before retirement.

Instead of systematically building substantial nest eggs through a steady stream of deposits to investments that perform best when held for long time periods, the retirement plans of many Americans are constantly hindered by withdrawals that diminish balances and sabotage optimal returns.

Connecting the dots, Brigitte Madrian, one of the study’s co-authors, and business school dean at Brigham Young University, says retirement savers should really have two nest eggs, “one that’s hard to access, and one that can be tapped almost at will.”

Sounds perfectly logical, and in fact, that’s pretty much what a lot of financial professionals recommend. But many Americans don’t do it.

Why Don’t Americans Build Cash Reserves?

A bunch of issues, large and small, conspire against saving.

One of the problems is semantics. “Saving” and “investing” are often seen as interchangeable terms. But while both words connote setting aside money for the future, “savings” (i.e., cash reserves) are for unforeseen needs or opportunities, while “investments” are typically connected to specific future objectives, like retirement or college funding.

With two distinctly different accumulation objectives, saving and investing should probably have separate accounts. “If you only have one account, then it de facto becomes the ‘everything’ account, so people no longer think of it as a retirement account because it’s serving multiple purposes,” says Madrian,

The problem isn’t just fuzzy definitions; current economic policy discourages saving. To soften the fallout from the 2009 recession, central bankers deliberately lowered interest rates, and have kept them down. This may have averted a global financial crisis, but when a year’s worth of interest from a $1,000 deposit barely pays for a latte at your local café, many consumers are ambivalent about building cash reserves. A 1% yield (or less) on savings is de-motivating.

Some retirement experts blame the structure of qualified retirement plans in the US; compared to formats used in other countries, “It’s too easy for people to access their money right now, and lots and lots of people are doing it,” says Ms. Madrian.

But imposing tighter restrictions on early withdrawals to stop leakage is problematic. Defined contribution retirement plans like 401(k)s are primarily funded by voluntary employee deferrals on income already earned. Further restricting access to money that’s already been earned might decrease long-term accumulation, because employees may feel that without some options for emergency withdrawals, they can’t commit to long-term investing.

And there’s the psychological quirk financial behaviorists call “present bias”; consumers tend to excuse overspending in the present while planning to be more responsible in the future. They rationalize going over budget this month, but simultaneously commit to substantial 401(k) withholdings to show they are serious about getting back on track. When their overspending and lack of savings catches up to them, they have to dip into their long-term investments.

The Employer-Sponsored Rainy-Day Account

To resolve the saving dilemma, the Harvard paper proposes employer-sponsored programs that pair a qualified retirement plan with a rainy-day account, from which workers could withdraw limited amounts of money to meet emergencies. Employees would commit to a single deduction amount from each paycheck, which would be divided between the two accounts, according to pre-established criteria.

The less an employee has in rainy-day savings, the greater the percentage of contributions go to this account. As cash reserves build, the amount invested in the retirement plan increases. When a withdrawal is made from the rainy-day account, deductions are recalibrated until the cash reserve balance returns to a previously agreed-upon level.

The concept is simple, but the devil is in the details. Combining an accessible rainy-day account with a qualified retirement plan would require different standards for

accounting, contribution limits, taxation, withdrawals, and product options. That’s more work – and responsibility – for employers. But the study’s authors think the benefits would be significant: “(W)e believe that automatically enrolling workers into an employer-sponsored payroll deduction ‘rainy day’ or ‘emergency’ savings account could be a cost-effective means of helping households accumulate liquid savings to meet possible urgent pre-retirement expenditure needs.”

A Validation of the Protection-First Approach

The only novelty in the rainy-day account idea is having an employer “nudge” you toward doing it. Perhaps the real news here is retirement experts acknowledging the essential nature of cash reserves. This validates the “protection-first” approach to personal finance, which is embodied in the phrase: “Tomorrows come next, todays come first.”

Consumers might associate the protection-first philosophy with life and disability insurance, a will, and other policies or legal devices, and those items are essential components of financial protection. But saving for today’s unforeseen events is equally important in keeping your plans for tomorrow from being derailed.

Retirement accumulation is often presented as a stand-alone issue, with experts of various stripes trying to boost either deposits or returns through new platforms or products. But unless retirement accumulation is integrated into the bigger picture of your financial life, you may always struggle to achieve your long-term objectives. While some see protection-first as just one opinion about how to order your financial life, these new studies say it’s an approach that sets the stage for long-term success.


Lifetime Financial Growth, LLC is an Agency of The Guardian Life Insurance Company of America® (Guardian), New York, NY. Securities products and advisory services offered through Park Avenue Securities LLC (PAS), member FINRA, SIPC. OSJ: 244 Blvd of the Allies, Pittsburgh, PA 15222 (412) 391-6700. PAS is an indirect, wholly-owned subsidiary of Guardian. This firm is not an affiliate or subsidiary of PAS. 2019-78967 EXP 4/2021

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