Cash Management
Cash management is often an undervalued topic in financial planning. The first reason it’s undervalued is that cash is normally a low-yield or low value asset. Another reason is that, unless you’re storing large amounts of cash for a planned purchase, cash is often a minimized component of a plan; however, in almost every plan, cash is normally the first step, and more importantly, cash generally identifies the health of many stages in planning. If cash doesn’t exist, there’s often a major problem. For this reason, cash management, although often overlooked, is a critical component of any financial plan.
Cash management isn’t often discussed beyond establishing a nondescript emergency account. I like to organize cash management as a combination of risk management and asset management. If you’re more conservative in your planning and investing, you’ll likely hold on to a bit more cash; conversely, if you’re more aggressive in your planning style, cash doesn’t provide upside access to economic activity, so you’d likely store a bit less of it.
How much cash?
I like to establish a cash goal based on current living expenses and adjust over time. Consider your current living expenses, and ask yourself these two questions:
1. How much money does it take to live each month in your current lifestyle?
2. Theoretically, how much money would it take to live each month if you trimmed your lifestyle to the essentials only?
The first living expense is simply called your current living expenses. Your current living expenses assume you are still earning income at the same rate as normal, and you’re living your life as you have been. There is no paring down any expenditures or cutting costs. This is a good number to know, and if it seems like a high amount, then you can analyze where, if any, unnecessary expenses are.
The second living expense calculation is called your basic living expenses. This might be your necessary fixed expenses (mortgage, minimum debt payments, utilities, etc.) and a modest grocery bill. You can add any expense you see fit, but I like to remove all luxuries from this calculation; in a true emergency, how low could you make your monthly lifestyle expenses?
After considering these two living expenses, you can see how much money it would take to live 3, 6, and 12 months with both your current lifestyle and a reduced, albeit stressed or basic lifestyle.
So how much cash do you need? That’s always a personal preference, but a good starting point is three to six months of expenses. If you’re more conservative in your planning, you might want to keep a multiple of your current living expenses in cash, but if you’re more aggressive, you might utilize your basic monthly expenses as the measurement.
When There are Bigger Goals
Cash calculations based on monthly expenses don’t consider bigger financial goals. For example, if a physician’s goal is to start their own practice, then the traditional cash goal may not be as impactful as it is to an employed physician. A private practice might be viewed as both an investment and a career, so if there’s a goal outside of the traditional financial planning process, then it might make sense to calculate the cost of the goal and work backwards from there.
If there’s a bigger objective, such as starting a practice, that’s driving the financial plan, the timeline of when the objective becomes relevant might play a role in cash management. If the objective is imminent, then cash accumulation is likely the only planning consideration. If the objective has a bit of a longer timeframe, then it might be suitable to hold less cash and rely on growth assets to help with the goal. Of course there is market risk to consider, especially if funds will be needed on a specific day.
Reestablishing the Goal
When clients are putting their initial plan together, and they often don’t have many assets yet, it might be worthwhile to stockpile cash to an extent. Once other assets are established, especially liquid assets, such as brokerage accounts, there is often less of a need to hold onto too much cash. Generally, investments inside brokerage accounts can be liquidated within a day or two, so these accounts can act as a backup to cash accounts in a true emergency. There is risk to liquidating securities, as market adjustments could impact the value when the funds are needed.
Easing into less cash
Once a cash goal is established and achieved, it’s time to move on to the next step of your plan, which often entails building other, more growth-oriented assets. I like to revisit the cash goal about a year after achievement.
When you first determine your initial cash goal, it is likely you were either just starting your plan and hadn’t yet saved much money, or you had accumulated a large amount of cash and hadn’t decided what to do with it yet. Either way, the planning process around cash management was relatively new, and there will likely be some hesitancy for financial change.
After the “shock” of the basic change has worn off, there will be an opportunity to reassess your actual cash need. It’s likely that other assets are being developed, and the actual amount of needed cash might have fluctuated. When changing your basic habits, such as determining an amount of cash to keep in the bank, people are often initially over-conservative. Once the habit has been normalized, it’s easier to reassess their actual risk capacity in determining their cash reserves.
Operating Capital vs. Storing Cash
Once you hit that sweet spot where you have your cash amounts dialed in an ideal system, the next question is a bit more technical: where do you put the cash? Of course you’re using cash in your everyday life to make your household function, so you’ll need to keep a portion of the cash in an account readily available to pay bills and use for normal spending. With your income regularly replenishing your account, the operating capital needed to be kept available might not be a large amount, so it makes sense to not want to keep too much cash idly.
If this is the case, you’ll probably be on the lookout for a high-yield savings account. Many banks have these accounts, and you can even look to the online banks to shop yield if needed. It should be noted that unless large amounts of cash are being stored in a savings account, the yield won’t likely be life-changing.
For example, a $50,000 balance in a high-yield savings account will return $2,000 annually at 4% interest, and the interest will be taxable as income. While interest income can be great, there could be a benefit to forgoing the high-yield savings account and keeping the cash management as simple as possible. The decision on where to keep cash, once the cash goal is met, is a personal decision.
Other Considerations
While cash management and cash goals should be a personalized decision, there are a few things to keep in mind when making these decisions. Banks and credit unions have insurance for account holders up to $250,000 per ownership category. The insurance (FDIC for banks and NCUA for credit unions) protects account holders in case a bank becomes insolvent. Different ownership categories may qualify for separate coverage, potentially allowing a depositor to have more than $250,000 insured at the same bank.
There are plenty of individuals who want to keep more than $250,000 in cash, so if that happens to be the case, consider utilizing multiple banks and ownership categories. Some banks also offer programs that spread deposits among multiple FDIC-insured institutions, allowing much larger cash balances to receive FDIC coverage.
The Bigger Picture
Ironically, when a person starts their financial planning journey, cash is normally the measuring stick that determines the health of the plan. When assets, other than bank accounts, develop in a plan, holding onto too much cash can become worrisome and even counterproductive. Cash doesn’t allow for much market growth, so when inflation is considered, cash usually becomes a depreciating asset over time.
While cash will likely always be an important tool in a financial plan, cash doesn’t necessarily “move the needle” alone in a plan. I think we should measure our cash based on our monthly expenses (unless there are outside circumstances dictating otherwise), and then we should consider the assets we own that can be quickly turned to cash, such as stocks and mutual funds in a brokerage account. Utilizing a larger reference point in viewing your cash positions can create a more efficient financial plan by not focusing on holding too much cash at any given point.
Further information: What to do once you reach your cash goals (VIDEO)