In this article I will explain how you can set up your investments so that you have access to your money when you need it. This is known as liquidity. If you go to a competent financial advisor, they will organise this for you. It’s a fundamental aspect of the industry. However, I am going to show you how you can organise your investments yourself. As a result, you will save yourself thousands of dollars! Now keep reading and I’ll explain all of the steps.
Pensions have terrible liquidity!
A problem for many people is being able to access their money when they need it. For example, one of my clients paid into a pension plan in the UK and then moved to the US. For tax reasons he can’t move his British pension to an equivalent 401K in the US. As a result, he will have to wait that out until he’s 65!
I had a similar problem moving in the other direction (from the US to the UK). I had a Roth IRA in the States. My problem was not transferring it but actually continuing to contribute to it. I carried on contributing to my Roth IRA and then was charged a tax penalty! So, I cannot continue to contribute to it until I return to the US.
Pensions will punish you!
Consequently, pensions are notoriously bad for allowing access to your investments. In most cases, you cannot access any funds until you retire or you have to pay a hefty penalty. Pensions provide terrible investment liquidity.
This happened to me when I got laid off from PwC. At this time, I had student loans to pay and a brand-new car. I needed to be able to pay these bills while I looked for a new job. But I had no income!
Pensions are a terrible emergency fund
I did, however, have a 401K pension plan with only about a year’s worth of contributions in it. It was the only investment I had. Moreover, I didn’t have an emergency fund. So, I cashed it in. Now a 401K will allow you to take early distributions under certain circumstances. Unfortunately, my circumstances (being unemployed with bills to pay!) didn’t apply. So, I had to pay a hefty penalty in order to get “my money” back. I felt very bitter about this.
But they do have great long-term benefits…
However, pensions provide amazing benefits as well. They are very tax efficient vehicles. In fact, depending on the type of pension you can contribute tax free! In other words, you can avoid paying income tax on the amount that you contribute to the pension. And the pension returns are also not taxed (but only if you don’t withdrawal them).
Even better, most employers will provide a matching (or higher) contribution to your pension. Free money! How can you turn this down?
So, pensions are very attractive in their tax treatment. You can also get additional funds from your employer to increase your contributions. On the other hand, you have to wait until retirement to access these funds. How do you resolve this dilemma?
The key is to structure the rest of your investment portfolio so that it has sufficient liquidity. As a result, you will be sure you can achieve your short-term goals.
The Investment Framework has the answers!
The answer is, once again, the Investment Framework. Consider two important things:
- Your reasons for needing access to your funds
- And how these needs fit into the Goal-Pyramid
As I said, another way to think of “accessibility” is liquidity. In other words, how liquid is your investment? How quickly can you turn your investment into cash? Once you have liquidated your investment you can then use the cash to meet current needs.
Think like a professional and keep liquidity in mind…
Most importantly, professionals think of investments in these terms. They rank their investments in terms of liquidity. This is because accessing your investment is slightly different to liquidating it. For example, pensions are usually fairly easy to access. But only if all you want to do is change the asset allocations.
Also, you can usually fairly easily change your retirement age. You can probably also change the beneficiary (to your children for example). But accessing the cash or liquidating your pension is costly or impossible.
We are converting investments to cash
So, when we talk about accessing the cash in our investments, we are talking about how quickly we can convert that investment into cash. In other words, how quickly can we liquidate the investment?
If we want, we can rank various investments by their liquidity:
- Savings accounts
- Certificates of deposit
- Stocks and bonds
- Real estate
- Pensions (Roth IRA, 401K)
The actual ranking may change based on your circumstances. For example, if you are 55 years old, you can probably liquidate your pension immediately. But if you are 35, you probably can’t.
Real estate is not liquid!
You will see that I have placed real estate quite low on the liquidity list. In other words, real estate usually has poor liquidity (unless you invest in a real estate fund). I underline this point because real estate is such a popular investment. Many people will have 100% of their investment portfolio in real estate. Sometimes in one property!
It is important to consider this carefully. For example, suppose you have a personal emergency, such as being laid off. You might not want to liquidate your entire real estate investment just to get some cash for living expenses. Furthermore, it could take months (even years in a depressed market) to get your money back. This is not a position you want to be in, in an emergency.
Liquidity is a key part of the Investment Framework
Let’s reconsider the Investment Framework:
- You need to know what your goals are, and how much they will cost.
- Calculate the return you need.
- Determine your risk tolerance.
- Consider what your constraints are (your time horizon, liquidity needs, taxes, legal and regulatory constraints, and any unique circumstances).
- Decide what assets you want to invest in.
- How much you want to or can contribute.
- And review annually.
Above, I have highlighted the key elements that relate to accessing your investments. Liquidity and goals. When we consider goals, we also need to consider the Goal Pyramid:
As I mentioned in an earlier article this approach has been popularized by Ashvin B. Chhabra. In this approach you establish different portfolios with different sets of goals. Because each portfolio has different goals, they will have different time horizons, tax concerns and liquidity needs!
Obviously with your retirement portfolio, you don’t need to begin liquidating this until you retire. However, you will want ready access to your emergency fund. As I said before, you don’t want to be in a position where you are liquidating real estate investments when you need cash!
You need a short-term goal portfolio
However, rather than be in the position of liquidating your emergency fund whenever you need cash perhaps, we need another portfolio. We could call this the Short-Term Goals Portfolio. This would sit between the Retirement Portfolio and the Emergency Fund. It would have high liquidity.
So, what would be the purpose of this Short-Term Goals Portfolio?
Get married, buy your car, go on holiday!
Above all, the purpose would be for you to save for those essentials that you need in your life. A wedding, a car, a holiday or a deposit for a house, for instance. Moreover, these will likely be things that you cannot pay for directly from your salary. However, you also don’t want to have to dip into your emergency fund. Or, make a costly withdrawal from your retirement portfolio.
The need for these things will be more urgent than your retirement portfolio. However, there may be an argument for placing this portfolio between the retirement portfolio and the Aspirational portfolio. Maybe a luxury car is less important than retirement. But you definitely need somewhere to live. So perhaps you can prioritize. And then form two new portfolios. You can place one of them below the retirement portfolio. And the other goes above the retirement portfolio (but below the Aspirational portfolio). Certainly, you will have to make this choice for yourself.
How to choose between competing goals.
As an example, one of my clients, Jim, wanted both a wedding and a new car. Firstly, we left aside the decision of priority and considered his circumstances. Subsequently, we determined that based on his current salary he could not afford both right now.
It would take 2 years to save for either a wedding OR a car. So, he would have to decide which goal to save for first. He decided that getting married was more urgent. His fiancée would never forgive him if he bought a car instead. And then saving for marriage would no longer be an issue for him…
So perhaps we can reconstruct the pyramid like so:
Understand your priorities
This represents Jim’s current priorities. We might argue that perhaps the retirement portfolio should be a higher priority. However, for Jim, getting married is a lot more urgent. He doesn’t want to wait until he’s 65 years old before he gets married and starts a family!
The sooner you prioritize the easier it is…
It is also possible that Jim can work on many of these goals at the same time. It depends on his income. But even if his income won’t cover all of these goals simultaneously, if at age 25, Jim spends two years doing nothing but saving for a wedding, he will still have plenty of time to save for retirement afterwards.
Firstly, it turns out that Jim’s income was $80,000 per year. He is a successful web developer. Secondly, after taxes, living expenses, mortgage, etc. he’s left with a disposable income of $20,130 (let’s just say $20K). How does he divvy this up into his various portfolios?
Make sure you have your emergency fund in place first
So, we assume at this stage that Jim already has an emergency fund in place. Therefore, we can focus on his other goals. Currently, Jim uses an old car to get around. But, he has his sights set on a brand-new Honda Accord with some extra options. This will cost him around $35,000 when he buys it in 4 years.
But before that, he needs to pay for the wedding. He’s worked out that this will cost around $32,000. In addition, he and his fiancée want to get married in two years.
Keep your retirement in mind
And then he also has his retirement to pay for. Jim has a mortgage and so he expects to have his house paid for before he retires at 65. So, his future living expenses (including disposable income) in today’s terms are around $31,000 per year. Consequently, in 40 years’, time, assuming average inflation, he will need $111K per year to live on.
For example, we can assume that Jim is able to conservatively earn a 4.5% return on his retirement portfolio. He could achieve this through an annuity, for instance. Therefore, he will need a retirement portfolio of around $2.5m. Can Jim achieve this while also paying for his wedding and car?
What about liquidity?
Again, we also have to consider the problem of access or liquidity. If Jim needs the money for his wedding in two years then using his 401K to save is a very bad idea. If Jim was able to get a withdrawal from his 401K for his wedding then he would pay some serious penalties. It simply wouldn’t be worth it. So, he needs another investment.
Recall from the Investment Framework that liquidity constraints are a key concern. In this case, Jim’s liquidity constraint is the need to pay for the wedding and the car. So, he needs to choose appropriate investments.
Would an index fund work?
Jim could easily invest in an index fund, for instance. It’s easy to open an account at Vanguard or Fidelity and start trading. These funds tend to have good liquidity. On the other hand, the return on index funds can be very volatile. For example, Jim could invest his money in the S&P 500. But, it will be very difficult to predict what the value will be in two years when he needs his money. It could earn 40% over two years. Or the stock market could crash right before the wedding, cutting his portfolio in half. While the stock market would eventually recover, this could take years.
Imagine Jim trying to explain to his (ex?) fiancée how he gambled their future in the stock market…
Be conservative with short-term goals
Certainly, a more conservative investment would be a Certificate of Deposit (CD) in a bank. But, yes I do rail against banks and their lousy returns. However, currently CDs provide rates up to 3.35%. Now after taking account of inflation this would probably be a small loss after two years. But Jim is not trying to make a profit here. He is trying to achieve an important life goal.
Jim can buy a series of CDs that mature in two years’ time. He won’t have access necessarily during this time, but the money will be there when he needs it. Furthermore, if he has concerns about the stability of banks, he can get a number of CDs with different banks. Deposit amounts range from $2,000 to $10,000.
There are options…
Now it doesn’t have to be CDs. Jim could try short-term government bonds for example. But these are much more complex than CDs and also have inherent risks. Because government bonds (such as Treasury Bills or Treasury Bonds) pay a fixed amount of interest, the value can go down when interest rates go up. Why is this?
Bonds expose you to interest rate risk…
Say for example, you buy a bond for $1,000 paying 3% interest per year ($30). Later, the government issues new $1,000 bonds paying 6% per year ($60). So now your bond is relatively less valuable. If you sell it later (before maturity) then it is likely that you will get less than $1,000 back.
This is because an investor buying this bond from you will apply a discount. This discount will likely be the value of the difference between the two rates. The amount of this difference will be depending on when the bond matures (i.e. when the Government pays back the $1,000). If there was exactly one year to go then it would be $30.
Liquidity problems in reverse!
Also, If Jim is being paid interest in cash, he has the problem of having to reinvest the money. Does he buy more bonds or just put the interest into a savings account? This is the liquidity problem in reverse. In other words, you get your money back before you want it!
Bonds are more versatile but also more complex
On the other hand, bonds are much more versatile than CDs. It is possible that Jim could put together a portfolio of bonds with various maturities that would earn more than the rate on the CD. However, we are introducing a lot of complexities here. Consequently, it is likely Jim would need professional (and expensive) help.
In short, it’s probably not worth all this trouble for a 2 year and relatively small investment. What Jim really needs is certainty of outcome. And not have his investment lose value should the market go down significantly.
In other words, Jim must be certain that he has the $32,000 for the wedding in two years’ time.
Do the math!
I’ll use the financial calculator to figure out how Jim needs to put aside for the wedding. If we assume Jim earns a rate of 2.5% on his CDs then with an annual payment of $16,000 (actually $15,797 – the 2.5% saves Jim a little on payments), in two years Jim will have the $32,000 for the wedding. Happy days.
Since he has a disposable income of $20,000, Jim has $4,000 per year to put towards the car. Since the investment horizon for the car is 4 years, perhaps Jim can take a bit more risk here. What Jim can do is open an investment account. Secondly, he can put this $4,000 into a diversified portfolio of perhaps 20% stocks and 80% bonds. As a result, this portfolio shouldn’t be too volatile and should earn around 6.40% per year on average.
First goal down…
In two years, Jim will have the wedding paid for and will have around $9,000 towards his car. Subsequently, he can shift the focus towards saving the remaining $25,000. There are 2 years left before Jim will buy the car. Therefore, it is probably a good idea to shift the $9,000 into a CD account.
Since Jim only needs to save about $12,500 per year, he now has a surplus of $7,500 per year. Therefore, he can begin saving this in his retirement account. At this stage in his life (now 27) Jim can afford to be quite aggressive with his retirement portfolio. So, he can put the remaining $7,500 in a portfolio with perhaps 80% stocks and 20% bonds. This will have an average return of 9%. Obviously, this a long-term investment.
Jim buys his car in cash!
In two years, Jim now has the $35,000 to buy his Honda Accord. He also has $16,000 saved towards retirement.
We discovered earlier that Jim needs a portfolio of £2.4m. After buying the car Jim is now 29 years old. He wants to retire at 65 then he has 36 years left to achieve this goal. How much does he have to put aside per year?
Next, we will assume that Jim will (on average over the course of his life) have a portfolio of 50% stocks and 50% bonds. Accordingly, he can expect an average long-term return of 7.75%. This means he will need an annual payment of $12,700. Given his disposable income of $20,000 he has a surplus of $7,300.
Surpluses are great!
He can use his surplus for other goals. Holidays, a second home, open a business, give to charity or pay for his kids’ goals. The main takeaway here is that Jim did the following:
- Firstly, he identified his goals
- Secondly, he quantified his goals in amounts
- Next, Jim prioritized these goals
- After that, he picked appropriate investments
- Finally, he was able to access the cash in these investments as he needed it
- Jim succeeded in meeting all of his goals!
Don’t worry if you’re starting late…
Now many of you reading this are probably a decade or two older than Jim. Maybe you wish that you had been as organized as Jim when you were younger. I certainly do! But don’t worry. 99% of people need to be on the planet for about 40 years before they know what they are doing!
I used Jim as an example because it is a relatively straightforward way to illustrate the point. As we grow older, we have to introduce complexities such as kids and debts. But the good news is that this concept applies no matter how old you are.
…you will be as certain as possible you’ve made a good choice.
By using the Investment Framework, you can organize your goals. You will know how much they cost. You can determine where to invest and how to invest. And you will know the precise investments to pick. In short, you will be as certain as possible you’ve made a good choice.
Leave a Reply