Financial Planning 101 - The Importance of Cash Reserves

The first element of a financial plan is related to cash reserves and cash flow. Having an adequate cash reserve can be essential, as it may allow you to meet your short-term cash flow needs and be prepared for any unforeseen or unexpected financial events.

Clients will often ask how much they should have in cash reserves, and while there are some rules of thumb it does vary by individual situation.

The first step to determining the appropriate cash reserve is knowing your own cash flow, specifically your monthly expenses. This includes your housing, food, health care (including insurance), utilities, transportation, personal expenses and debt service. Add to it your discretionary expenses like entertainment, dining out, vacations, etc. There are many apps or online programs that can help you track your spending habits.

For clients that don’t want to track expenses, a simple way to back into that number is to take your gross income, then subtract out income taxes, savings (including 401(k)) and account for any changes in liability balances or cash accounts over a certain period. Very often, this may result in a higher expense number than what a client thinks they may be spending.

Once you get a feel for the monthly spending number, the rule of thumb is to have 3-6 months’ worth of expenses in a primary cash reserve, like a checking or savings account. If you are spending $5,000/month on average, the targeted primary reserve would be $15K-$30K.

This is just a rule of thumb, though, and can be impacted by many factors:

Do you have other non-IRA assets that can be accessed in an emergency and are you willing to take the chance that you may need to access those funds when markets are down if an emergency arises? If so, you could choose to be on the lower end of the recommended reserve.

Do you own a business or have variable income? Owning a business, especially one where income fluctuates seasonally or otherwise, would argue for a higher cash reserve, potentially much higher so that you can handle the times when income wanes.

Do you own rental property? If so, you will want to maintain higher reserves to account for unforeseen repair expenses or loss of income.

Are interest rates high or low? Interest rates impact your ability to borrow. If interest rates are low, you can afford a smaller reserve because you could always borrow funds via lines of credit or home equity, etc. if needed. If rates are high, you will not want to borrow funds for an emergency (and you’ll earn more on secondary cash).

Do you have extra purchases upcoming in the next few years (vehicle, home repair, other big items)? The value of these should be added to your reserves, especially in a higher rate environment so you can limit borrowing when the time comes.

Are you retired and have annual or monthly payout needs? Retired clients often like to have higher than normal cash reserves and that’s OK. Oftentimes clients may want to have 2-3 years’ worth of expenses in reserves in order to feel more secure. This can be just fine, especially if it allows the retired client to feel better about the taking some level of investment risk in order to try to achieve growth in other areas of their portfolios.

Of course, having a cash reserve doesn’t mean everything has to be in a checking or savings account. We offer clients things like brokered FDIC insured CDs of varying maturities from institutions all over the country, as well as money market accounts.

Having an adequate cash reserve isn’t a complicated process, but knowing your personal situation and priorities can help you determine your own cash reserve and cash flow strategy.