What do clients do with the cash when they receive large cash payments from, say, the sale of a business or a significant asset, such as a house or a work of art? You probably have advised them on designing and implementing cutting-edge tax and estate-planning techniques to maximize the cash proceeds of the transaction. But are you sure that your client is advised on how to handle the cash?
We find that all too often these clients park their money in low-yielding checking accounts until they need it elsewhere. Lately, market conditions — and headlines wailing about financial dislocation — have exacerbated the fear and confusion that lead clients to make this choice.
But putting money in a low-yielding checking account can be a serious mistake, leading to significant loss of earnings potential. It also can largely undo the savings you have worked so hard to achieve for these clients.
How can you help such clients? Educate them. At the very least, make sure you know these eight basic facts of financial life:
- know the differences among cash-like investments
There are two broad alternative places where cash could be invested: money market mutual funds and deposit accounts.
Money market mutual funds come in several varieties that can be selected based on the specific profile of the client. In general, money market mutual funds can offer more attractive short-term rates (compared to a checking account) with comparable liquidity. And deposit accounts, whether linked to the London interbank offered rate (LIBOR) or a fixed rate, can yield more than a traditional checking account while maintaining liquidity.
What should your client look for in each vehicle?
Focus your client first on the difference between a regulated money market fund and the more common “money market account.” The latter is a deposit subject to the general rules applicable to the institution holding the deposit. Only a money market mutual fund is regulated by the Securities Exchange Commission. SEC Rule 2a7 imposes limitations on the concentration and credit quality of assets owned by the financial institution to support the investment. For example, only a regulated money market mutual fund is required to hold at least 95 percent of its assets in investments rated A-1 or better; it cannot have more than 5 percent of any single issuer. Also, its investments cannot have a weighted maturity of more than 90 days (for example, they cannot be invested in auction rate municipal securities).
But for all a money market fund's safety, not all are created equal. Your client also should consider the rating of the money market fund. It's important here to distinguish for your client the difference between a AAA-rated money market fund and a non-rated money market fund with an “average” AAA rating. A fund with a “natural” AAA rating has to satisfy additional requirements designed to protect investors and to keep their investments liquid. For example, those funds may only purchase investments rated A-1 or better; they have stricter concentration limitations than lower- or non-rated funds; and their investments cannot have a weighted maturity of more than 60 (not 90) days. A non-rated money market fund with an “average” AAA rating certainly should have investments with equivalent credit quality to rated funds. But the non-rated fund probably does not follow the stricter concentration and duration limits, potentially making it more risky for cash investors.
Your clients should demand no less safety in a deposit at a financial institution than they do in a money market fund investment. That means making deposits only with highly rated financial institutions. Remember: a depositor is an unsecured creditor. Unlike an investor in a money market fund (that has assets underlying the investment), if the institution in which your client keeps a deposit fails, your client will be near the end of the line of creditors seeking to collect proceeds in liquidation. While insurance from the Federal Deposit Insurance Commission provides safety to a wide variety of depositors without respect to the financial security of the institution, most of your clients will have deposits in excess of the $100,000 limitation imposed by the FDIC. And while a client with $200,000 or $300,000 in deposits might divide them across several institutions to diversify that risk (and essentially expand the coverage of the FDIC), after a point that will prove unsustainable.
Very few banks in today's environment still boast a AAA rating. Not surprisingly, clients are rewarding the balance sheet strength of those institutions that can. The other side of that reality is that highly rated financial institutions generally pay less than their riskier counterparts must pay on deposits. When comparing money market funds with deposits, therefore, your clients should make sure that they are comparing returns on AAA-rated funds with interest on deposits at AAA-rated financial institutions.
Finally, size matters with all cash investments. It's best to have cash managed by the largest institutions that invest money or hold deposits for individuals as well as for corporations, governments and central banks. From a liquidity perspective, when investing cash, it's much better to be a smaller part of a huge fund or financial institution than to be a large participant in a small fund or financial institution.
- avoid higher-risk assets
With all the credit market woes in today's environment, investors should have learned the dangers of exotic “cash-like” investments. Still, you should remind your clients of these risks.
There have been too many problems in this sector, whether it's subprime debt, auction-rate securities or asset-backed commercial paper. It's better to stick with highly rated money market funds or deposits at highly rated financial institutions.
But if your client is not planning to use the cash for at least 18-to-24 months, it's probably wise to start thinking about investing in securities that could yield more than cash. For example, AAA-rated government, government agency and supranational securities, investment-grade corporates (with no more than 2 percent exposure to any single issuer) could provide additional return consistent with a longer time horizon. Likewise, depending on the yield curve at the time, longer-term deposits (for example, certificates of deposit) could add yield without conflicting with clients' objectives. You should remind clients, though, that some of those investments have price volatility and potential liquidity problems that don't exist with traditional cash equivalents.
- every minute counts
Clients should be sure to negotiate the exact timing of their cash payments. There are three important time elements to consider: time of day, day of the week and month of the year.
The time of day is significant because the cash investment options could vary materially during the course of a 24-hour day. If the cash is received after certain cutoff times, usually after 12 noon, clients might not be able to invest in higher-yielding money market funds for that day. Even if clients have missed a money market deadline, they shouldn't default to a checking account. Remember to look at higher-yielding deposit accounts.
This is not a minor consideration. For example: say that a client expects to receive a payment of $100 million that will arrive before noon. She could be able to earn as much as 1 percent more than in a checking account (on an annualized basis). That could amount to more than $2,000 for the day. If you didn't negotiate at what time of day your client receives payment, how many hours would you have to write-down to reimburse the client for the lost $2,000?
The day of the week the cash arrives also can be key. If something goes wrong at a closing and the money doesn't arrive until Friday afternoon, your client could be underinvested for three days — Saturday, Sunday and Monday — before there's a chance to deploy the cash in higher-yielding investments. Imagine that material cost to the client.
The time of the year also can make a difference. If payment is coming near year-end, you probably will have advised your client to consider whether postponing the payment until the next calendar year could reduce taxes. But did you consider the opportunity cost of not having the cash invested for those few days? In some cases, it might equal or outweigh the tax savings.
- tax status matters
Clients should consider whether their tax status will change after they receive the cash payment. Largely this is a question of whether they'll become subject to the alternative minimum tax (AMT).
The AMT has just two tax rates for ordinary income — 26 percent and 28 percent — while ordinary income rates can be as high as 35 percent. Your client might choose a different investment vehicle depending on whether she is subject to AMT. For example, if your client is not subject to AMT, she might invest the cash in a tax-free money market fund. If she is subject to it, she might want to use a higher-yielding deposit or a prime money market fund, because the after-tax returns may be higher.
- set up early to pay tax bills due later.
Typically, clients should set aside money that will be needed to pay tax due on their transaction. That tax bill is likely due on a predictable date, while the date on which a client might need the rest of the cash might be less certain. We find that it's good practice to separate the cash for the tax payment and invest it in a certificate of deposit or highly rated fixed income security with a maturity that matches the date on which the taxes must be paid. This way, once the tax bill has been estimated, the client can deposit a discounted amount in the CD or security that will pay on maturity the exact amount of the tax liability. Not only does this ensure that the money will be on-hand when needed, but also it means that your client is reducing the tax bill by the time value of money.
- currencies matter
If clients expect to receive cash in a currency other than U.S. dollars, they might want to hedge the foreign exchange risk before the transaction closes. A hedge allows clients to freeze whatever gains they might have (especially if they are selling an asset abroad and are not U.S. persons.)
The principal way to hedge the foreign exchange risk in the financial markets is with futures or options. For example, imagine that a client expects to receive proceeds on a date certain in British pounds and plans to convert the proceeds to U.S. dollars. If he is concerned that the pound might decrease in value (relative to the U.S. dollar) by the time the transaction is closed, he might buy British pound futures to offset any potential loss. By doing so, he will limit his loss to the cost of the futures.
- plan for lengthy delays
You might be thinking, “This analysis is all well and good, but in reality $2,000 is not material in my client's transaction.” In our experience, most people take twice as long to implement an investment strategy than they initially planned. In making cash investments, your client might find that he is holding cash for a much longer time than anticipated. No one should leave money in a low-yielding cash account on the assumption that he'll invest the cash soon. It's always best to plan for the cash management — before the cash payment is received.
- expect things to go wrong
It's common for closings to go awry. There might be a signature missing, a document might have been lost or an incorrect wire instruction has delayed the payment. We recommend that our clients spend time working out the exact wiring instructions in advance, and even have the payor wire $1 in advance of the closing to test the instructions.
You should examine the transfer instructions when you're drafting the deal documents to confirm that all the details are correct. You also should know precisely where the funds are coming from so that you can track the funds if they get lost.
— The information presented within this article is provided for educational purposes only and is not a solicitation for any product or service provided by JPMorgan Chase & Co. and its subsidiaries.
Edward J. Finley II and Anton Pil are managing directors at JP Morgan Private Bank in New York