- Frictional cash typically sits in an investment account because we just need some small level of cash.
- The second category is investment cash, which sits in an investment account to deploy for an investment opportunity.
- The third channel is reserve cash, money being built up up for savings. Often this is for short- to intermediate-term goals.
Our guest for this video is Michael Kitces. He is a financial planning expert and the head of planning strategy for Buckingham Strategic Wealth, co-founder of XY Planning Network and AdvicePay, and the chief financial planning nerd for the advisor education platform Kitces.com and the Nerd’s Eye View blog.
Christine Benz: Hi, I’m Christine Benz from Morningstar. Deposit accounts have been in the news recently. I recently had the opportunity to sit down with Michael Kitces, he is a financial planning expert, to discuss how investors and their advisors should be thinking about the safe portions of their portfolios.
Michael, thank you so much for being here.
Michael Kitces: Absolutely. My pleasure. Appreciate the opportunity.
Frictional Cash and Investment Cash
Benz: Well, we’re thrilled to have you here. I want to start by discussing what’s going on with safe assets. Investors have had a little bit of a scare over the past couple of weeks with the regional bank troubles. So, I’m wondering if you can share how you think about safe assets. It sounds like you kind of silo them into a few different categories. Can you walk us through that?
Kitces: To me, when we think about cash, particularly, I’m sort of assuming this realm of we’re investors, but we have other dollars as well, right? Like there’s a big bucket of lots of different places that cash can sit. So, I tend to think about this in three different groupings because we do it a little bit differently depending on what it is.
So, the first of what I think about is, I’ll call it frictional cash. This is the cash that typically sits in an investment account that often we need because we just need some small level of cash. Maybe it’s like I’m taking ongoing retirement distributions. I want to literally have to sell something every single time I take a monthly distribution out for retirement. In the advisor world, that might be for the very small fee sweeps that we generate. That might be no more than 1% or 2% of our cash holdings.
But in the context of that kind of frictional cash layer, frankly, there’s not a lot that we typically do with this. And in most investment platforms, this goes to some kind of cash sweep or money market funds. To the extent it sweeps to a bank, unless you have a very, very large account like a 1% that’s kind of sitting in cash to handle frictional distributions. We are not over FDIC limits. We may or may not get the best yield in a lot of cash sweeps. But if I have to trade into something else, then it’s kind of defeating the purpose of cash I really need available to fund my distributions. And so, I find for most investors whatever that very small amount of frictional cash is, it tends to just kind of sit there. It is what it is. It’s usually protected by the core protections that are in place of FDIC coverage for sweeps or whatever is there. And there’s not a lot to do with it.
The second category is what I think of as investment cash. So, cash in my investment account because I want to hold cash in my investment account. Some of us do that because we’re a little more active. We want the proverbial dry powder for future investment opportunities. Maybe we’re doing it because we simply want to be more conservatively invested and hold a cash allocation to buffer the volatility of markets. Now, this cash, I think of a little bit differently than the frictional cash. Frictional cash, the whole point is I need it to be available immediately. If I need to take a distribution today or tomorrow, I need it to be available immediately. When we get out of that realm and into investment cash, we usually view it a little bit differently. I want to be able to deploy it for an investment opportunity, but I don’t need access to it to spend right away. And because of that, what we see a lot of the time for investment cash is we don’t usually literally hold it in cash. Maybe we’ll trade into a money market fund. Maybe we’ll trade into an ultra-short-term Treasury fund and try to get a little bit more yield out of Treasuries. So, we can nominally call it a cash position because it’s not invested into traditional stocks and bonds, but we treat it a little bit differently. We usually shop a little bit more for yield, but we’ll often do it within the investment account because this is dry investment powder. I do want to have it available to invest. So, we shop for yield a little bit differently.
Benz: And a municipal money market fund …
Kitces: Absolutely. Like if I’m higher income and I don’t necessarily want the federal tax scrape, I may go into the muni side. But very much to that point, I’m investing for the investment characteristics of the cash, but I need it in my investment account because I’m planning to do something else with it for investment purposes at some point in some future.
Benz: So, importantly though, no FDIC protections necessarily there?
Kitces: Typically, no FDIC protections there. Now, that might be because I’m buying a Treasury fund and have the full faith in credit of the United States government instead. So, I typically still want to keep that very secure. The whole point is I’m not trying to take investment default risk the way I would with, say, a corporate bond where I get paid a little bit more for the default risk. That’s my bond allocation, not my cash allocation. But investment cash that we hold in that account often we’re not necessarily following an FDIC path. We’re following what’s the safest, secure, most liquid investment I can buy in an investment realm, not a cash banking realm.
Benz: Got it.
Kitces: The third channel then that we see, I tend to call reserve cash. So, money I’m building up for savings, often this is kind of short- to intermediate-term goals. These are weddings. These are house down payments and the like, where cash balances may be larger. I don’t just need this to fund my ongoing spending. I’m not necessarily going to invest it anytime soon. So, I don’t necessarily put it in my investment account. These are the dollars that we often sit in bank accounts, and we shop for yield. So, we see a lot of investors that take this and say, I actually want to maximize yield not because I’m trying to find which Treasury fund has the highest yield; it’s because I’m trying to find which bank, or probably these days, which online bank has the highest yield. Now, we even see services starting to pop up like MaxMyInterest that will shop the yield for you across multiple banks. They’ll say, like, we’ll find the highest yield. You don’t even have to stay on top of it and move all the money around yourself.
Now this shows up a little bit differently because, particularly if I’m building a sizable balance, it is a bank, so things like FDIC coverage matter. They may be larger accounts because if this is a big reserve I’m building up like really, really FDIC insurance might start to matter. Again, this is around where I find it interesting to look at some of the services like MaxMyInterest on the consumer side; advisors, we have tools like Flourish and StoneCastle that are building not only to, say, will help you shop for the yields but even will help you spread the money across multiple banks, so you don’t have to worry about $250,000 of FDIC coverage or $500 for your joint account. We’ll open multiple joint accounts for you at multiple banks and automatically spread the cash across multiple banks and manage the FDIC risk for you as a small layer for which they charge a small fee. So, it’s a very different kind of realm than the frictional cash, where I tend not to be worried about FDIC coverage, because just I’m well below any limits if it’s even being swept to a bank in the first place. It’s different than investment cash, where I’m shopping for yield, but I’m typically doing an investment interest and I’m just trying to find ultra-low-risk liquid investment vehicles versus what am I doing with my reserve cash where I’m shopping for yield and, at least in today’s environment, maybe managing FDIC coverage.
Treasury Funds and Federal Money Market Mutual Funds
Benz: That’s a great run down and a great way to think of it. I just want to come back to your point about talking about that investment cash and your point that potentially just think about owning a Treasury fund there, where from a practical standpoint, very limited risk of default, obviously.
Kitces: Particularly, if we get very, very short-term, like we don’t even want to take interest-rate, duration risk to the extent we can. So, how short-term can we get the funds? Because we’re just trying to get basically whatever the federal government is paying to park the cash for a very short period of time. But thanks to several Fed interest rates, that’s actually not a bad number right now compared to where it was for much of the past 10 years.
Benz: Right. So, comparing that, say, the federal money market mutual fund, no FDIC protections, relative to the bank FDIC-insured deposit, how should people size up the risks there and approach how to apportion their assets across those two silos?
Kitces: Well, the irony to me, if you want to get in the grand scheme of things, my Treasuries are backed by the full faith and credit of the United States government. Ultimately, if my government is going to default, if that’s the thing we’re worried about, FDIC isn’t going to have a lot to say as well at that point. We’re all ultimately rolling up to the same government that’s allocating dollars. So, yes, there are some nuances to the differences between how FDIC guarantees work versus just the outright credit default risk of a Treasury. But I think of them very much in the same category. Ultimately, these are all things that are backed by the faith and credit of the government. You either believe the government is going to make good on its debts and not default or not. If you want to get it to from a monetary end, the government has a lot of means to make sure it doesn’t default on its debts, including literally the ability to print money. That can create inflation and other problems, but it does cut the default risk down, which is why we have the credit ratings and the reserve currency status that we do.
So, when I look at it from that perspective, I really tend to think of these as very similar buckets in terms of the safety of the dollars. You do get a little bit of difference in the accessibility of the dollars. If I’m in a bond fund or a bond ETF, I’ve got to trade in and out of it. Technically, I’ve got to trade out of it and have the trade settle before I can move the dollars. It’s not a huge lag. But it means I can’t write a check against this account outright the way I can in the banking system. But again, if I’m looking at this from an investment cash perspective, it’s like, well, OK, I’m not trying to write a check against it. I’m getting ready to invest it in whatever my next investment opportunity is, because I’m holding it as part of my cash allocation inside of my investment account.
Benz: Well, Michael, this has been such a helpful discussion. We’ve covered a ton of ground. Thank you so much for being here.
Kitces: Absolutely. My pleasure. Thank you.
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