Establishing Cash Reserve Targets

We are frequently asked how to set an appropriate level of cash reserves in a client’s financial holdings and the answer is, it depends. It varies by individual and entity, the level of predictable expenses or distributions and whether there are other sources of funds besides the investment portfolio. But there are steps to follow to help with the decision.

The first step is estimating your cash outflows. Expenses include monthly living expenses, quarterly and annual tax payments, trips, annual house repairs and desired or required distributions for a non-profit. Establishing an estimate of expenses or outflows requires working on a budget or cash flow forecast, with an understanding of what normally occurs in your living or non-profit operating circumstances, as well as identifying less frequent expenses, such as replacing a vehicle. There are tools to help individuals and families with the budgeting process and your client centric team at Greenleaf Trust can assist as well.

A typical on-line search using the question, “What is the correct amount of cash reserves?” might provide the answer of three to six months of expenses. But for an individual or family, the correct answer may be more or less than this formula. For example, if a family has two incomes with cash inflows that exceed their monthly cash outflows, including amounts being set aside for savings, they may be comfortable with less than six months. For a couple in retirement, that has worked hard to build an investment portfolio to fund their retirement, a comfortable level of reserves may be 12 months to several years. The objective is to minimize unexpected sales from your equity, alternatives and fixed income allocations to pay expenses, particularly if one or more of these asset classes is experiencing volatility. This is different than the rebalancing among these asset classes that Greenleaf Trust performs in a client’s portfolio in response to market outcomes and circumstances and to manage to changes in a client’s risk tolerance.

Non-profits may have known outflows in terms of the amount and timing of those distributions. Depending on the entity, the cash management strategies may vary from keeping the known distributions in a money market fund to buying fixed income securities with maturities to match the distribution amounts and dates. Some entities have contributions to their portfolios, which also offset the outflows. While the categories of the budgeting process are different than for a family, the objective is still to understand and plan for cash flows so that an appropriate level of reserves may be established.

Once an individual or entity has determined through a budgeting process a level of appropriate reserves, the next step is deciding how to invest these funds. Money market funds have not provided a return since the Federal Reserve and the fixed income markets moved the returns on short maturity bonds to essentially zero as the pandemic unfolded. But that should change. Investors have already driven interest rates higher and the Federal Reserve will increase the interest rates that the Fed controls. This will eventually improve the return on money market funds and reduce the cost of holding funds in cash equivalents versus bonds, for example. In the capital markets assumptions that our research team prepares, our expectation is that pre-tax returns on cash investments will rise to 1.6% while our expectation for the pre-tax return on fixed income securities over the same time period is 2.2%. In addition, the price risk on cash investments is minimal, while there is price risk with fixed income securities which is driven by the maturity date of the bonds or the average maturity of the entire bond portfolio. As the financial markets have demonstrated thus far in 2022, there is the potential for considerable price volatility within the markets, including on fixed income securities.

If a potential need for funds is several years in the future, we may be asked if those funds should be invested in the equity market, rather than in a money market fund or short maturity bonds. While Greenleaf has a favorable outlook for equities over the long-term, we respect the potential for volatility in stocks over a shorter time period of three to five years. Our response to clients is what would be the impact on a major remodeling or building project, for example, if the equity market was experiencing a cyclical decline in prices and the available funds were less than the original investment?

Understanding and forecasting the timing and amount of cash needs from an investment portfolio is a critical step in the investment process. Whether it is through assisting with a cash flow modeling exercise or building cash distributions into the sustainability analysis that we perform for clients, your client centric team at Greenleaf Trust is available to help with your planning.