The Importance of Cash Flow in Your Personal Financial Planning
Cash flow is our financial life-blood. We tend to think of cash flow as something that only businesses or governments contend with, but it is integral to our personal financial lives as well. Cash flow enables us to do what we want, and to help achieve our goals or objectives — whether that is to get a mortgage, save for a college education, take a vacation, and of course, save and invest for retirement.
We’re all familiar with the phrase “cash is king.” Don’t get me wrong, cash is great, because it’s liquid and accessible. It’s like a refreshing bottle of water. But, once you drink all the water, you are left with an empty bottle. It’s the same with cash. When it’s spent, it’s gone. Cash flow, on the other hand, is like a water fountain. There is a constant stream of water you can drink, or use to refill your bottle, whenever you want. With the right strategy, your savings and investments will generate consistent cash flow.
In our working years, cash flow comes from our salaries through our employer or profits from a business. When we’re retired, ideally, we have accumulated enough money in our retirement accounts, such as a 401(k), IRA, or other accounts designated for retirement. The strategy is then to turn those assets into a reliable retirement stream of cash flow. Remember, the main objective to saving and investing is to eventually convert it into cash flow.
Wall Street teaches us to focus on the rate of return on our investments. However, we should instead focus on cash flow. That’s because you can’t spend rate of return. For example, if you have money in the stock market, invested in “growth stocks,” where the goal is appreciation in the stock price, in order to create “cash flow” from those growth stocks, you will need to sell shares. If the stock market goes up enough, you can simply sell enough shares to generate your retirement income. However, what happens when the stock market goes down? You have no positive rate of return. Therefore, you must sell shares at a lower value or perhaps at a loss. This is not a situation that you want to continue to be in for any extended period.
If instead, you saved or invested in something that generates cash flow (dividends, interest, rents, etc.), that cash flow is generally much more reliable and you won’t have to rely on a positive stock market in order to sell shares for your retirement cash flow needs.
Cash flow is important whether you are in the accumulation phase of your life (while you are working) or in the distribution phase (in retirement). But the thought process behind how you use this cash flow is different in each phase. For example, if you’re in the accumulation phase, you’re likely to reinvest the dividends or interest to help build up your account value. You are probably more risk tolerant as well. In addition, you will likely make mistakes (We all do. Live and learn, right?). Hopefully you will learn from those mistakes and improve upon your accumulation plan. Then, once you get to retirement, you’re likely to have the dividends, interest, etc. paid out to generate cash flow to support your lifestyle in retirement. You’re also likely to be more risk averse. In addition, unlike the accumulation phase, you only have one-shot at getting the distribution phase right. We won’t have any do-overs or bail-outs for us.
I’m also a big believer in building up tax-free (not tax-deferred) cash flow sources. We’ve been taught to put away as much money as we can during our working years into pre-tax retirement accounts such as our 401(k)’s. The assumption is that when we retire, we’ll be in a lower tax bracket.
Well, that advice was more appropriate years ago, when tax rates were much higher. The reality is, our country has a huge amount of debt and we have issues with Social Security, Medicare, and Medicaid. It’s not hard to imagine that the tax rates are likely to go up in the long term. You could find yourself deferring income now, yet, finding yourself paying taxes on that income at a much higher tax rate later on, when you withdraw it.
Some things to consider:
- If you can contribute to a 401(k), contribute up to the company match, but not necessarily above. Ideally, you want to save at least 15 percent of your salary toward retirement, but that doesn’t mean it all has to go into your 401(k).
- Look to make Roth IRA (or Roth 401(k), if available) contributions, which are taxed now but tax-free when withdrawn.
- Buy permanent life insurance, which accumulates cash value that can be accessed tax-free (via withdrawals up to basis and/or policy loans).
- Consider alternative investments, such as real estate. These generally provide cash flow and are also less correlated to the stock market. Ultra-high net worth individuals often have a wide range of alternative investments. However, you don’t need to have an ultra-high net worth to seek out these alternative opportunities.
If you are retired, or about to retire, you can look forward to spending 30 to 40 plus years in retirement. However, that also subjects to new risks, such as longevity risk and sequence of returns risk. Not to mention the “unknown” costs of healthcare and if long-term care will be needed. To make your money last throughout your retirement, you want to put your retirement assets where they can maximize your cash flow, and doing so with the least amount of risk.
I’m also a believer in creating guaranteed lifetime income. Social Security and, if available, a pension, provide guaranteed lifetime income. However, annuities are the only other financial product that a consumer can purchase on their own that generates guaranteed lifetime income. Therefore, you should consider taking some of your retirement assets and placing them into an annuity. Some types of annuities provide a credit while you defer taking out income to your “income withdrawal base” (this is different than your account value with the annuity). For example, you might get a 5-6 percent credit for every year you defer, up to a certain period of time (e.g., 10 years). That will increase the annuity’s income withdrawal base, even if the stock market isn’t doing well. Then, when you’re ready, you could withdraw cash flow, guaranteed for the rest of your life (based on the claims paying ability of the insurer) and, if applicable, your spouse’s life as well.
I address all of this in my upcoming book. In the meantime, remember the following; When you lose less, you make more, meaning consider less volatile investments. As Warren Buffet said: Rule #1: “Don’t lose money.” Rule #2: Don’t forget Rule #1.” Furthermore, you can spend more, when you have a guaranteed income stream. Lastly, don’t chase returns. Chase cash flow.
For educational purposes only. Investing involves risk – including the potential for a loss. Accessing cash values may result in surrender fees and charges and will reduce the death benefit and policy values. This information is based upon our understanding of current laws, which is subject to change. Please talk to a financial professional regarding your specific situation.