How We Create Personalized Cash Plans for Our Financial Planning Clients
Hold too much cash and you’re comfortably losing money to inflation.
Hold too little cash and you’re running the risk of being unable to deal with unexpected expenses.
A good plan on managing existing cash and current cash flow balances three factors:
Financial planning best practices
Your comfort with cash
An active approach to managing cash on an ongoing basis
In practice your cash flow surplus will determine how quickly your cash reserves grow, or become depleted.
A good financial plan will reveal this to you.
Consider the following:
Total inflows - total outflows = net cash flow
When you’re operating in a cash flow surplus, your current cash reserves are growing by this amount on an annual basis.
When you’re operating in a cash flow deficit, your cash reserves are being depleted by this amount on an annual basis.
In the example above, there’s $755,566 of total annual expenses. Financial planning best practices point towards having 3-6 months of living expenses on hand.
With dual-income households, like the example above, 3 months of expenses is generally viable.
An exception to this, is if 80% of the total income is generated from one household member. In this case, it’s best practice to hold closer to 6 months.
With a dual-income household with a fairly even income split, 3 months of living expenses for this example places total cash recommendations to be ~$83,000.
I excluded $340,801 of taxes because you need income for taxes to be assessed - if there’s a loss of income, taxes aren’t an expense incurred on lost income.
In plan recommendations, I like giving a range of recommended cash reserves - in the example above this would be $66,000 - $100,000.
This is a ~20% standard deviation from the recommended 3 months that I give to clients which gives room for life to get in the way.
This recommendation is met with a conversation around their comfort with cash.
This all sounds great - but if they want to hold 6 months, I’d look to understand their perspective and wiggle on our recommendation.
Cash reserves above 7 months and under 2 months of living expenses is typically where I’ll have a conversation around what their goals are to assist in guiding action.
In the event I’m successful in guiding action - great.
In the event I’m unsuccessful in guiding action after education - no worry - that’s what makes personal finance personal & I’ll note this in their financial plan.
Once cash recommendations are met, the goal is to ensure that their cash reserves are getting the highest rate of return.
At a high-level, I like to apply Pareto principle (80/20 rule) to holding cash - meaning, 80% of total cash should be placed in high-yield savings and/or a money market & 20% of cash should be readily available in a checking account.
You don’t need the full amount sitting in your checking - but you do want it to be liquid to ensure it’s there if you need it (& most importantly - not subject to market volatility).
On November 10th, 2024, current 1-month treasury bills are generating 4.51%.
Using our example above, this means:
80% of cash in a money market: $66,400
20% of cash in a checking account: $16,600
This would allow the 80% of cash in a money market to earn 4.51%/yr (at current rates) which would generate an additional $2,994/yr in interest.
20% is kept in the checking account where you spend regularly.
One important caveat is that in order to get favorable money market rates of return, you're likely going to have to open a brokerage account and invest your cash in a money market that’s publicly traded. The likelihood for your bank to offer you 4.51%/yr on your cash right now is slim to none (spoiler - banks paying you less than what they can earn is one way they make money). You’re going to have to do some work to get that return.
Next - if you don’t have cash reserves that meet the recommended emergency fund levels, then your plan would outline how to replenish cash reserves through your cash flow surplus.
If your plan reveals you’re operating in a cash flow deficit & you need to increase your emergency fund, then you’ll either have to reduce spending or increase income (not sexy - but that’s how it works).
If you have held cash above recommended cash reserve levels, then the recommendation would be to sweep excess cash to an account/asset where you can earn higher expected rates of return.
Using the example above, if $100,000 of cash was held, the recommendation would be to scrap additional $17,000 to one or a combination of retirement accounts, brokerage accounts, reinvestment in existing real estate or business ventures or accumulate for the next real estate/business venture (depending on goals).
Depending on the magnitude of your cash flow surplus, the recommendation may be to scrap more cash if current cash flow surplus is expected to replenish reserves quickly (although - the other part of the planning process would be putting that surplus to work for you - so that might be a non-issue).
Above all - the goal is to keep this cash flow system running.
We have 4 and 8 month check-ins after a formal annual review where this is attended to at least 3 times per year to guide action.
When emergency funds are low - replenish.
When emergency funds are high - scrap to other accounts.
Keep emergency funds in high-interest bearing accounts.
Simple in theory - but powerful in practice.
Add up the efficiency created from generating the highest rates of return on cash and the scrapped excess cash being put to work - this easily adds thousands, even hundreds of thousands of dollars back to your net worth.
This is the power of cash flow planning.