Strategy is what makes chess such a beautiful game. Financial Advisors also enjoy strategy, whether it is building portfolios, curating financial planning scenarios, or deploying risk management solutions for our clients. During this recent tumultuous market, we wanted to discuss the need for alternative cash techniques to win over our new opponent: inflation.
So.... you moved to cash when the market was unpleasant. Well, the amount of cash to hold depends on each individual’s strategy and personal circumstances - but you can't keep it there forever. Keep in mind there are plenty of reasons to hold cash in places like your checking and savings account, such as to have easy access to those funds for day-to-day expenses.
First things first, we want all our clients to keep an emergency fund. This is a cash reserve specifically set aside for unplanned expenses and financial emergencies. Once you have this balance (typically three months of income) saved in a liquid account, you should feel confident to deploy any additional cash into other vehicles. Generally, we suggest getting a threshold so once your cash reserves reach a certain level, you can follow a process of putting your cash to work.
Holding cash has a significant chance of a real negative return over time due to inflation risk. This implies that your cash loses value over time. Uninvested funds gradually lose value over time since they are incapable of keeping up with the effects of inflation. As a result, the $100 “under your mattress” will gradually only be able to buy $98 worth of items, then $96, then $94, and so on.
Holding too high of an allocation of cash restricts you from the possibility of earning higher returns through investments in other asset classes. Therefore, you fail to benefit from the money that can compound over time and garner even higher returns.
We have put together some options for you, which of the below matches your risk tolerance best?
1. CASH TECHNIQUES TO CONSIDER
What are ‘CD’s? They are called a certificate of deposit and the money is locked away for a certain amount of time – whichever term you select. I would say this is the more restrictive of the two options below. Terms can range from months to years. However, if you need the money back before the term expires – you pay a penalty. The advantage would be that the interest rates are higher than typical savings accounts and it is typically a fixed rate (not a variable rate). You do not have the option for check writing, debit cards or instant liquidity.
What are Money Market Accounts? These typically pay a higher APY (Annual Percentage Yield) than savings accounts – on a tiered schedule of course. With higher balances and higher account minimums, brings higher yields. Many of these accounts come with check writing privileges – but come with a limited number of withdrawals.
Emergency Reserve: Traditional Checking or Savings Accounts.
Short Term Goals: Utilize Savings or Checking Accounts.
Mid-Term Goals: Consider Money Market for a higher yield.
Long Term Goals: Consider a CD to lock in a fixed rate to save away cash to purchase a home for example.
2. PERHAPS A VARIETY OF BONDS:
Stocks and Bonds usually share the same conversation when talking investments, but they have many differences – but let’s start at the top. Think of Bonds as a loan to you from someone else (usually government or a company). No equity is shared, and no shares are traded. In return, you are paid interest on said loan over a pre-determined time. I would say these are transparent – you know what you get plain and simple.
Pros: Bonds tend to rise and fall less dramatically than stocks, which means their prices may fluctuate less. Certain bonds can provide a level of income stability. Some bonds, such as U.S. Treasuries, can provide both stability and liquidity.
Cons: Historically, bonds have provided lower long-term returns than stocks. Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.
Both I and EE are offered by the US Treasury:
I-Bonds – Rates are adjusted to protect from inflation. Great for conservative, low-risk investors ready to park some cash but protect against inflation. These are sold directly from the Treasury Direct Website (no secondary market for buying/selling).
EE-Bonds – offer guaranteed return and the rate is fixed for life. The most interesting thing about these are that they double in value over 20 years. If rates and inflation are low, could be a good chess move for long term investors.
Muni Bonds – In general, these are used to fund public projects: highways, hospitals, schools, roads, etc. Consider these for a relatively low risk, tax-free income source – and see your funding produce parks and buildings in front of your very eyes. Best of all, they are generally exempt from FIT (Federal Income Tax) and have some state income tax benefits.
3. REVIEW YOUR FIXED ANNUITY CHOICES:
Annuities are designed for retirement income as “live-on” assets but may default to wealth transfer as “leave-on” assets when clients don’t need or want more income. Complicating the conversation is the fact that the legacy rules for annuities – nonqualified, qualified and Roth – are unique.
These products can be confusing – each one comes with unique rules, options, features, benefits – which can be overwhelming! For this conversation, let’s keep it high level: we are talking about non-qualified cash assets (above and beyond your liquidity and emergency reserve) being utilized to fight inflation.
How fixed annuitieswork: You provide a lump sum to the annuity company and in return they promise you a guaranteed minimum return. The returns are predictable, the minimum rates are guaranteed, the principal is relatively safe, income payments are guaranteed, and the growth is tax deferred.
Sounds great right? There should be cons right? The funds are relatedly illiquid (surrender periods up to 15 years), the withdrawals if any are limited, the fees are higher than other types of investments. These are important to consider before making this strategic move.
4. WHAT ABOUT THE STOCK MARKET?
Most of you are already invested in some way in the market: a traditional IRA, workplace 401k plan, or government sponsored retirement plan. Have you invested after tax money in an investment account – not linked to your retirement? These types of accounts are not restricted to annual contribution limits or tax incentives. These are referred to as non-qualified accounts and you can invest as much or as little in any given year. They can include a variety of investments, most common would-be mutual funds, and equities. The money invested in these have already been taxed by an income source, they come straight from your bank account – minding your liquidity and emergency reserves of course.
As you can see below, we kept this riskier chess move at the end of the conversation as the benefits are overshadowed by market exposure. With upside comes risk and with risk may come reward.
The game of chess is to win over your opponent, and in this case the opponent is inflation. Cash may be 'king', but just remember inflation has a significant impact on purchasing power and that some portfolio growth is necessary to maintain wealth. No matter what your next move is, it is important to maintain focused and that strategy is key. After you lock in your emergency reserves, mobilizing that additional cash into a vehicle that aligns with your risk tolerance is the key to battling inflation.
There are several investment choices we did not cover today that might be a good fit for you and our cash deployment strategy. Please reach out our team to schedule your next financial planning meeting!