Many people consider cash as a short-term asset – the money that sits around in a bank until it is needed. However, cash in and of itself is not inert. The moment the money earns a lower yield than the country’s average monthly inflation rate, it begins depreciating in equal measure. The yield spread between the two is, on average, higher than most people realize.
Cash complacency has a cost
We’ve seen the averages recently – roughly 0.45% APY for a savings account at the national level (FDIC, early 2024). And high-yield fintech accounts regularly see rates around 4.5%. It is easy to think, “I could’ve done better,” but that does not mean that the opportunity cost has not impacted the individual.
Let’s say one had saved $10,000 in a savings account with a 0.45% APY. After five years, that person would have earned around $227 in yield. With the same initial sum, a high-yield fintech account at 4.5% would have earned roughly $2,462. This is a difference of more than $2,200 on a single $10,000 balance, assuming no additional capital is invested in the meantime.
If the same individual had $50,000 in cash to invest, this is the opportunity cost for keeping their money in a savings account. This is not an insignificant sum for someone who keeps the sum of a down payment, an emergency fund, and a general business fund in one place, as is common for those balancing the needs of a business against personal expenses. It is not just that these cash holdings are depreciating, but rather that their purchasing power is gradually eroded by a combination of inflation and the lack of yield on savings. A 3% inflation rate for an individual who earns 0.45% on their idle cash is a guaranteed loss of approximately 2.5 cents per dollar per year.
The problem is simple – it is the implementation that is difficult due to inaction on the part of the individual. The root reason for the problem is usually twofold – the perception of idle cash as a static asset and the general lack of understanding of which instruments are relevant in a person’s financial situation.
Establish a multi-tier liquidity structure
Instead of focusing on the absolute value of APY, build a general hierarchy of needs for the management of idle cash. The individual must understand that different categories of their cash assets require different levels of liquidity. It is unwise to keep everything in a high-yield savings account because that would prevent the person from having ready access to their emergency fund in case of an immediate need for cash. The easiest way to approach this is to separate cash assets into three categories: first-level liquidity, second-level, and third-level.
First-level liquidity is cash that is needed to satisfy expenses that can arise within 24-48 hours. This is the emergency fund and the monthly operating capacity of the person or household. It is the only category that should be kept in a high-yield savings account so that it is fully liquid at all times. The size of this category should be based on the individual’s or household’s monthly expenses – roughly three to six months’ worth.
Second-level cash assets are those that the individual will not need for at least a month. This category is appropriate for investments in a flexible CD, in a money market fund, or a similar instrument. The individual should earn a higher yield on this category than on the first since it is less likely to be withdrawn suddenly. The third category is all cash assets that can be tied up for longer than six months. It is those sums that the individual can afford to leave untouched for a year or more. The third category enjoys the highest potential yields but at the cost of liquidity.
If the individual manages their own liquidity structure, they can build a CD ladder for a multi-tier approach by dividing the sums according to their needs. Third-level funds are suitable for a CD ladder to maximize yields on all sums. The idea of a CD ladder is to diversify risk by tying sums in CDs that mature at different times so that a portion of the investment becomes available for withdrawal every year as a steady income stream.
A CD ladder helps to ensure fixed-rate income with greater liquidity than a standard CD would allow.
CDs have fixed rates upon purchase, which is beneficial if the individual foresees a decrease in the federal funds rate. At the same time, the individual must understand that their cash is tied up for the duration of the agreement. The alternative to a standard CD is a CD ladder that spreads the risk across CDs that mature at different times – for example, one that matures in three months and another in six, nine, and twelve months. In this way, the individual is never deprived of liquidity for more than one year.
With such a structure, the individual will be able to make regular monthly or quarterly contributions to their CD ladder, renewing and reinvesting the maturing sums in new CDs with higher yields if the federal funds rate has decreased or keeping the same rate if the opposite is the case.
Lifestyle yield and why it matters
APY is not the sole contributor to the growth of cash assets. That is the opinion of many fintech-savvy individuals who take advantage of a growing number of financial instruments at their disposal. The yield on their balances helps to increase their spending or investment capacity. However, the benefit of fintech products is that the fintech companies themselves often provide additional services based on the customer’s balance. If the fintech company offers the customer access to concierge services or other luxury perks in exchange for maintaining a particular balance, the customer enjoys an increase in the quality of services they receive with every additional dollar on their balance. This is known as a lifestyle yield, and it is one of the most effective ways to maximize the value of one’s cash.
Some of the most progressive fintech companies, such as Stoa, the savings platform that unlocks lifestyle perks, recognize the importance of lifestyle yield: the greater the customer’s balance, the greater the selection of travel and dining rewards, first-rate access to events, and other unique benefits they have at their disposal.
The concept of lifestyle yield has broad applications, including for those who already spend freely on dining, travel, and leisure. For the individual who spends $5,000 a year on travel, access to a $1,000 annual credit from the fintech company means that they now enjoy the benefits of an increased yield without additional costs.
Money market funds: what to know
In many ways, money market funds are similar to savings accounts. Both instruments allow the individual to preserve their cash assets with a yield. The difference is that a money market fund is an SEC-registered investment company that invests in short-term notes and other low-risk instruments. Money market funds provide higher yields to investors than banks and fintech lenders do on their savings accounts. Additionally, government money market funds typically provide consistent and reliable yields. However, those yields come at the risk of losing some of the value of the investment, as the shares of the fund can fluctuate in value. They rarely, however, fall below $1.
For many investors, money market funds are most useful at the time when their yields significantly exceed those of savings accounts. For an average investor, there is no point in keeping large cash sums in a money market fund inside their brokerage account, as a high-yield fintech account provides better liquidity and safety. At the same time, a money market fund is often the best option for first-level cash liquidity, as it is FDIC-insured, meaning that the investor never loses their initial investment.
However, investors should understand the differences between a savings account and a money market fund. The two instruments are similar but have different mechanics: a savings account insures the customer against losses, but its yield depends on the decisions of the Federal Reserve. A money market fund generally offers a more consistent yield but is subject to market forces. If, for example, the yields on short-term instruments skyrocket, a government money market fund can temporarily offer a higher yield than an ordinary savings account. This factor becomes important if the investor holds a large amount of Tier 3 cash in their brokerage account.
Navigating sweep accounts at fintechs
Cash sweep accounts are becoming increasingly popular among fintech companies, especially among those with brokerage services, as a way to attract customers with higher FDIC insurance limits. The way sweep accounts work is that all of the customer’s cash is distributed among a number of program banks. In other words, every sweep account user has a portfolio of banks, each of which holds a part of the customer’s cash assets. The more banks the fintech has in its program, the higher the FDIC coverage the customer can expect from their cash sweep account. The largest fintechs with brokerage services can offer their customers coverage of hundreds of millions of dollars with their sweep accounts. At the same time, it is necessary to carefully examine the characteristics of the sweep account, as sometimes companies put their interests ahead of customer security and profits.
Several questions should be asked before deciding to use a cash sweep account:
Are the program banks transparent and easy to research?
Does the fintech explicitly indicate that FDIC coverage applies to the sweep account?
Are there any additional fees, such as monthly account maintenance fees, or minimum requirements that must be met to receive the announced yields?
What are the withdrawal terms? Is it available the same day or only on the next business day?
Are there any reports on the performance of the sweep account, and what is the reputation of the fintech with which the customer is about to open an account?
The last two points are critical to researching the fintech company before investing large sums of money. If the company is unknown and difficult to research, be wary of suspiciously high yields.
Interest rate cycles and cash management basics
The yields on variable-rate deposits are directly related to the policies of the Federal Reserve. When the central bank lowers the federal funds rate, the yield on all kinds of savings accounts decreases. The size of the decrease varies from tool to tool and institution to institution, but it is usually significant enough that the change becomes noticeable to the average person on the next statement. This poses the greatest challenge to cash management when the Federal Reserve is expected to lower the federal funds rate soon or has already begun to do so.
The primary solution when the central bank decreases the federal funds rate is to convert as much of the Tier 3 liquidity as possible into fixed-rate instruments. It will allow the individual to protect the yield on the largest sum for the longest possible period during the anticipated rate decline. For example, if the Federal Reserve announces a rate cut within the next six months, first-level cash liquidity, second-level cash, and third-level cash should be allocated to instruments with a one-year maturity. If the Federal Reserve raises the federal funds rate, on the contrary, the investor should use instruments with a shorter maturity to take advantage of the rate increase.
Navigating rate cycles is not about predicting the future – it is about understanding that the balance between variable and fixed instruments must change depending on whether the federal funds rate is rising or falling. If the individual uses the multi-tier approach to cash management, the short-term yield from the first two tiers will alleviate some of the impact on the third tier when the time comes to renew it at a lower rate.
The takeaway
Effective cash management should not be based on the search for the highest possible APY at any given time. Instead, it should be focused on the principle of liquidity, which takes into account the different levels of immediacy for each expense. The multi-tier approach to cash management allows the individual to take advantage of high-yield accounts while maintaining the security of a traditional savings account and the opportunities offered by an expanding fintech ecosystem. The potential for lifestyle yield is one of the most compelling advantages of fintech deposits, although it should not be the only consideration. The combination of the three factors described above will enable the individual to get the most out of their cash assets. And all of this is possible with minimal effort on their part.