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With inflation outpacing yields on savings and money market accounts, what's a saver to do?

Question: I understand that you should have at least three months’ living expenses in a reserve account. But the interest rates available on savings and money-market accounts are so low that you end up losing purchasing power after inflation. Long-term CDs aren’t an option for cash reserves because you’d have to pay a penalty to get to your money and bonds have too much interest-rate risk. So what’s a person to do with his rainy day fund at a time like this? -Jeffrey Utech

Answer: I hear you. Last week, in their ongoing attempt to breathe life into a sagging economy, Federal Reserve chairman Big Ben Bernanke and his merry band of Open Market Committee members cut the target rate for federal funds for the seventh time since September, lowering it to just 2%.

As a result of those moves, short-term rates on everything from bank savings and money-market accounts to money-market mutual funds have been on a downward slide the past eight months and now average less than 2.5%. Inflation, meanwhile, has been cruising along at an annualized rate of 3.1% the first three months of this year. So it’s no wonder you have the feeling of being on a treadmill that’s going faster than you can run.

But as disconcerting as it is knowing that your savings stash is losing purchasing power at the moment, you’ve got to be careful not to make any rash moves that could make the situation worse.

After all, the primary purpose of a cash reserve is to be available when you need it. You want to be able to get at this money immediately without paying a significant penalty. And you don’t want to worry that some of it won’t be there when you need it because the market has taken a nosedive or interest rates have spiked. So that pretty much limits you to savings accounts, money-market funds and short-term CDs.

Naturally you want to earn a competitive return on these vehicles, which you can do by sticking to money-market funds with the lowest expenses and shopping for accounts with the most attractive rates.

Similarly, you’ll want to consider whether, depending on your tax rate and the relative yields on taxable and tax-free funds, you can do better in a tax-exempt fund. As of last week, average yields for tax-free money-market funds were around 2%, which for someone in the 25% tax bracket translates to a taxable equivalent of 2.7%. That’s a half percentage point or more than the average taxable money fund was paying.

But you don’t want the desire for higher yields to take you into investments that are inappropriate for cash reserves. So whenever I hear people talking about supposedly savvy ways to get “safe” high yields or returns - buying tax liens, foreign bank CDs, various types of annuities that carry high surrender fees, etc. - the first thought that pops into my mind (and I think should pop into theirs too) is whether you want to take a chance with money you need to be as secure and liquid as cash.

I believe the answer is no. And I think the experience of people who lost money in supposedly secure subprime mortgage-related investments and found themselves locked into auction rate preferred securities that were touted as substitutes for money funds illustrates the perils of reaching for yield.

I realize that this means there may be periods when you have to accept puny returns on your cash reserves, maybe even returns that lag inflation. But you’ve got to work with what the market delivers. You can’t just manufacture the returns you would like to receive, at least not without subjecting yourself to greater risks.

Of course, you can and should be willing to accept more risk for the possibility of higher returns in the investment portion of your portfolio - that is, the assets you’re investing for the longer term. And, indeed, it’s that part of your holdings - not your cash reserves or rainy day fund - that you’re relying on to keep your purchasing power ahead of inflation.

When it comes to your cash reserves, however, safety of principal is your main goal. So resist the urge to stretch for higher, riskier yields and instead stick to secure short-term savings vehicles, even if they’re currently paying puny yields. Rates will eventually tick up again. And when they do, you want to be sure your rainy day fund will still be around to take advantage of them.

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