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Can You Retire on CDs and Money Market Funds?

Can You Retire on CDs and Money Market Funds?



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This article was first posted February 1, 2000.

With the NASDAQ down as much as 50% off its highs, many skittish investors are asking, "Can I retire if I put everything in CDs or a money market fund?" If you're very rich and can save enough to retire despite low investment returns, that's certainly an alternative (though a poor one.) Unfortunately, while everyone portrays Certificates of Deposit (CDs) and money market funds (MMF) as being the safest investments around, they have risks of their own -- mainly inflation.

Table 1. below shows inflation-adjused investment returns for the S&P500 and Table 2. shows the inflation-adjusted performance of 3-month commercial paper for holding periods of 10 to 60 years based on 130 years of historical stock market data compiled by Yale University economics professor Robert J. Shiller. The returns on 3-month commercial paper approximate what an investor would earn in a money market fund or short term CD. In terms of safety, let's look at the worst 10-Year holding period for each. The worst 10 year period for stocks had a negative 3.87% per annum average return, after inflation. That means an initial $10,000 investment would have had the spending power of $6,739 in today's dollars at the end of 10 years. The worst 10-Year period for 3 month commercial paper resulted in a negative 5.17% average annual return over 10 years. A $10,000 investment would have declined to $5,881 in inflation-adjusted terms after 10 years. Even in the worst of times, for investors with a time horizon of 10 years or more, stocks handily beat CDs and money market funds.

The median return (i.e., in 50% of the holding periods examined an investor earned more, in the other 50% of the periods examined, less) for the S&P500 versus 3-month commercial paper showed dramatic differences. An initial $10,000 investment in the S&P500 grew to $19,893 after adjusting for inflation at the end of 10 years at the 7.12% annual average return. The same $10,000 in a CD earning an average 2.36% return after inflation grew to only $12,627.

The differences in returns are even more striking for holding periods longer than 10 years. An initial $10,000 investment in the S&P500 earning the median annual average return of 6.77% would be worth $264,552 after 50 years. A similiar $10,000 investment in a CD would grow to only $15,964 at the 0.94% average annual inflation adjusted return.

Table 1. S&P500 Returns (1871-2000, inflation-adjusted)
------------------------------------ Holding Period -----------------------------------
Percentile 10 Year 20 Year 30 Year 40 Year 50 Year 60 Year
(Max) 100% 17.72% 13.06% 10.14% 9.84% 9.31% 8.28%
90% 13.78% 10.54% 8.69% 8.65% 8.38% 7.43%
80% 11.23% 8.89% 8.26% 7.65% 7.74% 7.12%
70% 9.87% 8.23% 7.48% 7.26% 7.14% 6.95%
60% 8.49% 7.28% 6.89% 6.95% 6.91% 6.83%
(Median) 50% 7.12% 6.76% 6.35% 6.58% 6.54% 6.77%
40% 5.80% 6.14% 5.94% 6.23% 6.13% 6.60%
30% 4.62% 5.02% 5.32% 5.81% 5.89% 6.25%
20% 2.74% 3.40% 5.07% 5.36% 5.70% 6.04%
10% -0.10% 2.52% 4.41% 4.89% 5.37% 5.60%
(Minimum) 0% -3.87% 0.89% 3.35% 3.67% 4.83% 5.26%
Periods 120 110 100 90 80 70
Table 2. ----- 3 mo. Commercial Paper (1871-2000, inflation-adjusted)
------------------------------------ Holding Period -----------------------------------
Percentile 10 Year 20 Year 30 Year 40 Year 50 Year 60 Year
(Max) 100% 8.28% 7.80% 6.48% 5.58% 4.23% 4.56%
90% 6.87% 5.58% 4.66% 3.38% 3.67% 3.52%
80% 5.26% 3.65% 2.63% 2.71% 3.02% 2.44%
70% 3.61% 2.76% 2.31% 2.32% 1.91% 1.24%
60% 2.76% 2.30% 2.10% 2.10% 1.26% 1.08%
(Median) 50% 2.36% 2.03% 1.77% 1.76% 0.94% 0.94%
40% 1.76% 1.59% 1.33% 0.87% 0.68% 0.79%
30% 1.12% 1.31% 0.95% 0.57% 0.55% 0.75%
20% -0.38% 0.35% 0.25% 0.26% 0.43% 0.68%
10% -2.24% -1.37% -0.57% -0.22% 0.33% 0.61%
(Minimum) 0% -5.17% -2.80% -1.35% -0.46% -0.12% 0.43%
Periods 120 110 100 90 80 70
Table 3. S&P500/Cash Returns at the Efficient Frontier (1871-2000, inflation-adjusted)
------------------------------------ Holding Period -----------------------------------
Percentile 10 Year 20 Year 30 Year 40 Year 50 Year 60 Year
(Max) 100% 11.34% 9.93% 8.12% 8.25% 8.18% 7.31%
90% 8.79% 8.14% 7.39% 7.24% 7.37% 6.75%
80% 8.01% 7.52% 6.78% 6.62% 6.85% 6.49%
70% 7.14% 6.81% 6.37% 6.43% 6.38% 6.36%
60% 6.56% 6.13% 5.91% 6.05% 6.07% 6.24%
(Median) 50% 5.39% 5.64% 5.51% 5.71% 5.87% 6.18%
40% 4.49% 5.24% 5.23% 5.39% 5.77% 6.09%
30% 3.48% 4.32% 4.89% 5.10% 5.53% 5.91%
20% 2.19% 3.37% 4.57% 4.84% 5.28% 5.67%
10% 0.00% 2.41% 4.11% 4.58% 5.01% 5.39%
(Minimum) 0% -2.78% 1.06% 3.23% 3.73% 4.41% 5.04%
Periods 120 110 100 90 80 70
% Stock 44% 66% 74% 77% 82% 85%

One might ask if a mixture of cash and stock improves investment returns much like it increases the "100% safe" withdrawal rate during retirement. (See the Retire Early Study on Safe Withdrawal Rates.) Table 3. answers this question. A cash/stock portfolio improves "worst case" returns for 10-Year and 20-Year holding periods, but falls behind for 30-Year holding periods and beyond. Holding 5 years worth of living expenses in cash and CDs is sound advice for a retiree, it actually reduces the return for an individual saving for retirement 30 years from now.

What about Inflation Bonds or TIPS (Treasury Inflation Protected Securities)?

TIPS and I-Bonds are superior to CDs and money market funds as a long-term buy and hold investment. However, they fall far short of historical inflation-adjusted returns in equities. The current inflation-adjusted yield on the 30-Year TIPS is 3.66%. The current interest rate on the I-bond (which may be held for 30 years at the option of the owner) is 3.40%. The worst 30 year period for the S&P500 gave investors a 3.35% return. Indeed, the current 3.66% return on TIPS was breeched to the downside in only two out of the one hundred 30-Year accumulation periods for the S&P500 examined from 1871 to 2000. A decision to use TIPS as a vehicle for accumulating retirement assets requires at least an implicit assumption that we are currently in the worst 2% of the time for the stock market.

Should anyone hold 100% CDs or money market funds?

There is one segment of the population that logically (though maybe not successfully) holds 100% cash and CDs as part of an investment strategy. Market timers believe they can divine the future direction of the stock market and move to cash in advance of a market decline. Those that possess this unique ability will at times hold 100% cash or money market funds. Unfortunately, the jury is still out as to whether anyone can successfully time the market for a 50 or 60 year lifetime of retirement saving. An individual with even semi-perfect market timing could amass a large fortune in short order using leverage -- it wouldn't take 50 years. Investment fans are still waiting for the first market timer to be inducted to the Forbes 400 list of wealthiest Americans.



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Copyright 2001 John P. Greaney, All rights reserved.


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