Bob and Jane keep $150,000 in a 0.25% savings account, forcing their remaining $600,000 to earn nearly 10% annually to hit their 8% target. Moving just $100,000 to investments earning 5% instead of 0.25% adds hundreds of thousands over 30 years. Excess cash in low-yield accounts quietly drains long-term wealth.
Each one of us needs financial liquidity in our daily lives. What exactly is financial liquidity? Access to cash, either in your pocket, in the bank, or through other financial assets such as a checking or savings account. In the case of an emergency, there is peace of mind knowing you can write a check or visit your bank. Many financial experts recommend keeping a few months of liquidity for living expenses in case of unemployment. A stock market correction, or other financial dilemma. This certainly can be a good thing, but as the old saying goes, you can have too much of a good thing. How can too much liquidity be a bad thing? Usually, accounts that provide immediate access to the funds inside them offer very low returns. For the average person, the proper amount of liquidity could be $25,000 or even $50,000, depending on their lifestyle and the length of time they are planning for. Much more than this, and you can actually begin to experience the detrimental effects of too much liquidity. We call this the high cost of liquidity. Meet Bob and Jane. They are financially conservative and are a few years away from retirement. They have saved and invested well for retirement, but after experiencing the financial crisis of 2008, the COVID pandemic, and the resulting worldwide shutdown, Bob and Jane decided to have a larger emergency fund than what the experts recommend, with 20% of their savings set set aside as liquid. Bob and Jane have saved $750,000 total, with $150,000 in a savings account, and they enjoy the peace of mind knowing they can access those funds at any time. But what Bob and Jane don't realize is how expensive it can be to keep such a large portion of their savings in a low-yielding savings account. Bob and Jane have a nice home, newer cars, good health insurance through their employers, and very little debt. Their retirement lifestyle will require about $30,000 annually of spendable income from their investments to supplement their other sources of retirement income. This is known as the income gap or shortfall and actually presents a significant risk to a successful retirement. The challenge here is that they're relying on 80% of their savings and investments to grow enough to generate the $30,000 income they need to supplement their retirement lifestyle. What they fail to realize is 20% of their savings is sitting idle and is putting a lot of pressure on the 80% they've invested. If Bob and Jane's goal is to earn 8% on all of their money, the 80% they've invested will need to earn almost 10% annually to offset the meager returns their savings account is paying. Let's look at the effects over a long period of time to understand just how expensive the high cost of liquidity could be for Bob and Jane. First, let's say Bob and Jane keep $50,000 liquid instead of $150,000 and invest the extra $100,000. Before we go any further, we should note that Bob and Jane cannot remember a situation that has ever required immediate access to such a sum of money. Yes, they've had home repairs, they've had medical bills, they've even had expensive car repairs, but none of those instances ever required having access to $150,000. Or even $50,000 for that matter. So let's look at what the extra $100,000 could grow to over the next 10, 20, and 30 years for Bob and Jane's retirement. We will look at 3 different scenarios: a low return of 3%, a moderate 5% return, and then finally 8%. At 3%, in 10 years the $100,000 would become approximately $134,391. And $180,611 over 20 years, and finally $242,726 over 30 years. What will 5% over the same time periods yield? Well, they would have earned approximately $162,889 over 10 years, $265,329 over 20 years, and finally $432,194 over 30 years. As you can see, a return of just a couple percentage points more makes a tremendous difference when compounded over a long period of time. Now let's see what 8% looks like across those same time periods. In 10 years, 8% would turn $100,000 into approximately $215,819. Over 20 years, $466,095. And finally, over 30 years, it would become approximately $1,006,265. Now let's look at their savings account, which is yielding just 0.25% over those same time frames. In 10 years, their savings account will have grown to $102,528. $105,120 over 20 years, and $107,778 over 30 years. What Bob and Jane fail to realize is just how incredibly expensive it can be over a long period of time to have too much of their savings in a position where it is yielding so little in return. The difference in their retirement lifestyle in future years could be drastic when comparing these different scenarios. One way of looking at this could be, what if the bank gave you a bill for keeping your funds liquid after 10, 20, or even 30 years? That bill would be for tens or even hundreds of thousands of dollars. However, when we consider the long-term effects we just saw, the effect is similar. If you are in the same situation as Bob and Jane, we recommend exploring other options for your excess emergency funds. Let's explore some options to make sure you're not a victim of the high cost of liquidity.
