Updated January 2014 — Whether your goal is to accumulate assets to generate future cash flow or support your current cash needs, developing a cash flow strategy should be an important consideration when creating your wealth plan. Yet developing specific strategies to generate cash flow is often an overlooked aspect of wealth planning until the actual need for cash arises. During economic downturns, people naturally become concerned about their ability to maintain lifestyles and focus on their cash flow needs. Conversely, when economic times are good, people naturally tend to focus less on their basic day-to-day needs and more on enhancing their lifestyles, giving to charities or passing wealth to their heirs. Regardless of whether the current market cycle is trending downward or upward, meeting your ongoing cash flow needs is a critical part of your financial life.
Step 1: Define Your Cash Disbursement Goals
Focus on defining your day-to-day, week-to-week and month-to-month needs first. You can focus on other financial goals once you are comfortable that your basic needs and lifestyle likely will be met. As you identify your financial goals, you should quantify each goal into a target amount and establish a target date. Perhaps you anticipate needing $200,000 per year in living expenses. That’s your goal, and the dates could be from now until a few decades in the future, say 2010 to 2039.
Step 2: Define Your Sources of Cash Flow
The next step is to determine the cash flow you expect to receive from sources other than your financial assets, and the expected amounts and dates for each source. Perhaps you expect income from Social Security and from serving on a board of directors. Record the target income from each source and the years you expect you will receive it.
Step 3: Determine Cash Flow Needed From Your Financial Assets
Armed with the information from Steps 1 and 2, you can develop a cash flow projection. The initial purpose of the cash flow projection is to determine the amount of cash flow that can be satisfied through sources other than your financial assets. Another purpose is to determine how much of, and when, you’ll need your financial assets to meet each of your financial goals.
Step 4: Define Your “Number”
Your “number” is the amount of cash (and cash equivalents) you need on hand to be comfortable and so that you can pay your bills at any time. Your wealth plan needs to account for not only cash flow needs, but also risk tolerance. Perhaps your number is six months worth of living expenses. For more risk-averse investors, that number may be close to two years’ worth of living expenses. Generally, most wealth plans hold closer to 12 months of day-to-day living expenses. Whatever your number may be, these funds should be set aside in cash or cash equivalents and treated separately from your investment portfolio.
Step 5: Define Your “Window”
Your “window” is the time horizon your cash flow must be “locked-in” for you to feel comfortable you will be able to maintain your lifestyle into the future. You don’t want a market downturn to cause an abrupt change in lifestyle, so planning for a time horizon that is appropriate for your circumstances is vital. For example, consider retirement. If you’re many years away from retirement, your window may be much longer than that of someone who is already retired. Look at your various investment goals.
Each of your life goals will have a different window, and your wealth plan should account for all the different windows in your life. For some goals, the window may be two to five years, for others five to seven years or perhaps even longer. By defining your windows, you and your investment advisor can define an asset allocation for each financial goal and design a portfolio to help meet your cash flow needs during your windows.
Step 6: Develop Your Investment Strategy
You should work with your investment advisor to develop an asset allocation for each goal based upon the time horizon, required return, cash flow and liquidity needs, risk tolerance and minimum acceptable return for each goal. Then, an investment strategy can be developed to help achieve each goal. This investment strategy can be tested through statistical modeling methods, such as Monte Carlo Simulation. The back testing helps determine the target amount of assets needed at a specific date to meet future goals.
Step 7: Implement and Monitor Your Wealth Plan
The final step is to tactically implement your cash flow strategy and have it regularly monitored by your investment advisor to help provide the amount of cash flow you need, when you need it. As part of the monitoring process, your investment advisor will review the performance of the various asset classes within your portfolio and periodically rebalance the portfolio as appropriate.
During stock market upturns, your allocation to equities and alternative investments may increase relative to your fixed income investments. The natural movements of the capital markets may throw your investment strategy out of balance from your target asset allocation for your wealth plan. Gains can be harvested from an over-allocation to equities and alternative investments and reinvested in fixed income. The reinvestments are structured to help build out additional years onto your cash flow, extending the window.