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Columns: Dr. Don
Don Taylor, Ph.D., CFA, CFP   Expert: Don Taylor, Ph.D., CFA, CFP
Ask Dr. Don
Laddered approach would be better
Ask Dr. Don

$200,000 emergency fund is excessive
 

Dear Dr. Don,
I am 73. I sold my small business a few years ago and since then have avoided the volatility of the stock market. Most of my money (about $1 million) has been invested in tenant-in-common, or TIC, 1031 exchange real estate to ensure a fairly steady income and to avoid taxes.

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I have put aside $200,000 in cash in case of an emergency. I was earning 5 percent in a savings account, but that percentage now is down to 3.8 percent. Right now, I am trying to find a safe place to park that $200,000 with a better return. Do you have any suggestions?
-- Howard High-yield

Dear Howard,
The Federal Reserve has reduced its targeted federal funds rate by 3.25 percent -- from 5.25 percent to 2 percent -- since September 2007. Money market (cash) interest rates and high-yield savings account rates are highly correlated to the federal funds rate. The downward movement in yields is to be expected.

Still, I have some suggestions for you.

I think your emergency fund might be a bit bigger than you need, and you could invest some of those assets somewhere besides cash. However, I may be underestimating the liquidity needed for your real estate investments. An emergency fund is typically sized to represent three to six months of expenses.

I like Treasury inflation-protected securities, or TIPS, for part of this investment. Sure, they're a bit of a nuisance to own in a taxable account but, depending on the maturity, you can earn 1 percent to 2.125 percent plus inflation. I can't tell you what you'll earn on the inflation component, but you should average somewhere between 2 percent to 4 percent for inflation, providing you with a combined return of 3 percent to 6.125 percent.

There's some price risk, because this investment is in five-, 10-, 20- or 30-year notes or bonds, and prices will change over time with the changing interest environment. The nuisance comes from how the IRS makes you pay income taxes on the inflation component each year even though you don't receive the money until you the security is sold or matures.

CDs can also work here. You take the risk of paying an early withdrawal penalty if you need the cash, but a laddered CD portfolio could provide you with a modest improvement over your current savings yield.

Laddered portfolio
Cash 3.44% $20,000
3-month 3.46% $20,000
6-month 3.66% $20,000
1-year 3.95% $20,000
2-year 4.00% $20,000
3-year 4.25% $20,000
4-year 4.55% $30,000
5-year 4.75% $50,000
Average: 4.15%

I put together an example of a laddered portfolio using Bankrate's Compare Rates feature. I picked up a quarter of a percent in yield over what you're earning now in savings, while 40 percent of your money still has a maturity of a year or less.

Keeping money in liquid funds for an emergency almost always brings down your overall investment returns. Not keeping excess funds on reserve helps minimize the drag. Being willing to accept a penalty for early withdrawal if you need the funds can also help.

Bankrate.com's corrections policy -- Posted: June 13, 2008
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