I recently wrote about dynamic cash allocation, which is the idea of prioritizing your excess monthly cash flow between building an emergency fund, debt repayment and investing, not just based on what gives the best after-tax return now, but also keeping in mind the inflation and time adjusted opportunities with that cash flow over time. For example, by paying down low-interest rate debt now, that excess cash is no longer available to take advantage of a future investment opportunity that could yield a much better rate of return.
I want to put this concept in practice every three months with some hypothetical clients, Drs. Hal and Stephanie Brown. The Browns are fresh out of residency. Hal is in internal medicine and Stephanie is an OBGYN. They have a gross salary of $400,000 (Hal earns $160,000 and Stephanie $240,000). Their take home pay, after taxes, health insurance, etc., is $260,000. They have the following debts:
- Hal’s student loans: $150,000 at 7% interest through a private lender, with 15 years remaining.
- Steph’s student loans: $180,000 at 4.5% interest through Navient, with 26 years remaining.
- Home mortgage: $400,000, 100% financed at 4% interest, 30 years remaining.
- BMW splurge: $40,000 at 1.9% interest, 5 years remaining.
- Credit cards: $16,000, rolled over to a 0% interest credit card with 12 months remaining before the APR will be 18%.
The student loan interest payments will not be tax deductible because their income is too high, but the mortgage interest will be fully deductible. To keep things simple, let’s assume that their effective tax rate, state and federal, is 30%.
Here are their assets:
- Hal and Steph’s 403(b)s from residency: $14,000.
- Home: $400,000.
- Emergency fund: $10,000 earning 1% interest. The checking account balance rolls over each month to pay expenses and so is not factored.
- Hal and Steph have each opened Traditional and Roth IRA accounts and will have access to a 401(k) at their jobs starting January 2017, with a 100% match of the first 3% of their salary contributed and a 50% match of the next 2% contributed.
After paying all of their expenses each month, including the minimum monthly payments on the above debts, life and disability insurance, and factoring a cushion for expenses that occur irregularly or unexpectedly, they will have $7,000 of excess cash flow on average per month. Note that this does not include a 401(k) contribution, as they are not yet eligible to contribute at their new jobs.
At the present time, in the real world, we can make educated guesses about the expected future return on some asset classes. For example, bonds tend to have a rate of return equal to their yield, so a intermediate-term U.S. government bond fund is expected to return about 1.5% and an international blended government bond fund is expected to return close to 0% per year. Using the US and MSCI indexes for stocks in comparison to this chart, it is reasonable to expect U.S. stock market returns of about 7% based on current prices, and 8.5% for foreign stocks, although I think both of those numbers are optimistic. While residential real estate tends to have a rate of return equal to inflation over long periods of time, REITs behave more like bonds, so the expected return of a broad basket of REITs right now is about 4%. Next, we subtract 1% for inflation from all of those rates of return.
It is important to keep in mind that the above estimates are not predictions, and the actual rate of return will vary, likely significantly. Nonetheless, we should try to make reasoned guesses so that we can determine what is most likely to be the best use of our excess cash flow, and, more importantly, what is not a good use of our excess cash flow. Also note that I am not going to provide the expected returns of other asset classes, such as commodities (which Bogle and Buffett advise against owning), small capitalization stocks and emerging stocks/debt, due to their small role in a portfolio and in an effort to keep things fairly simple.
Next, we need to compare the current expected rates of return described above and adjusted for inflation, against the inflation-adjusted (aka “real”) historical rates of return for those same asset classes. The historical, real rates of return over the past 25 years (or less depending on what I could find), after subtracting inflation at the historical rate of 2.5% during that same peirod, are as follows:
- U.S. stocks: 6.5%
- Foreign stocks: 2%
- REITs: 9% (this was so surprising that I double checked it through Vanguard)
- U.S. government intermediate bonds: 2.5%
- Foreign government bonds: 2.5%
- Cash (using 1 year Certificates of Deposit): 1.5%.
Credit to buyupside.com for the rate of return for the stock indices. Note that these are rounded for simplicity, but the exact amounts do not vary by much more than 0.1%. Also, these historical figures should not be taken as strict predictions of future returns, but rather as reasonable estimates of what the long-term return will be starting at an average entry point in the investment. So here is a handy chart to summarize where we stand:
Finally, we have a comprehensive look at the Browns’ debts, assets and opportunities, adjusted for taxes and adjusted for inflation, so that we can compare not only what is the best use of excess cash flow today, but also what may be the best use of today’s excess cash flow in the future, in terms of the opportunity cost of using that excess cash flow now or having it available in the future. Here are some initial observations:
- Just looking out over the next year, the biggest thing on the horizon is the 18% credit card interest rate. The credit card does not need to be paid down now, but the cash needs to be available to pay it off before the interest rate increases. If we are certain that the $7,000 a month of excess cash flow will continue to be available over the next year, then we could wait a few months to save the cash to pay off the credit card, but to be safe, and because the Browns’ emergency fund is only $10,000, saving to pay off this debt is the first priority.
- The second priority is building the emergency fund over the $18,000 for the credit card debt. Although cash has slightly negative real return (negative because of the taxes on the interest income) just sitting in the bank, and the Browns have student loans accruing interest at 7% (6% after inflation, and not tax deductible), it is best to build an emergency fund that would cover at least 2-3 months of expenses as soon as possible so as to reduce the odds of having to incur future credit card debt with interest rates of 18% or more. Yes, the Browns are paying 7% in interest during that time by keeping that excess cash flow in a CD or money market account, but I would not assume that 0% interest rate credit card offers will continue to be available, as credit markets could tighten as they have in recent history. Each additional month’s worth of expenses saved in an emergency fund increases the chances that credit card debt will not have to be incurred in the future. The incremental benefit declines with each additional month saved, but the first three months provide the greatest amount of benefit.
- Looking ahead, one of our next priorities will be taking advantage of the 401(k) match, especially the 100% match on the first 3% of salary, but also likely the 50% match as well, as that 50% match is a much greater rate of return than the Browns’ highest interest rate debt.
- After taking advantage of the 401(k) match, the 7% interest rate student loan debt (6% after accounting for 1% inflation) is likely the next best bet. Given that the 6% real rate of return by paying down Hal’s student loans is on the high end of what we can expect to earn on a blended invest strategy right both now and in the long run, it is likely best to pay down that debt as opposed to keeping it in cash and waiting for better investment opportunities.
- I’ve discussed what is high on the priority list, but not what is low. The BMW loan, even though it is the second lowest balance after the credit cards (which will be paid off soon), has the lowest tax-adjusted interest rate, and after factoring inflation, the interest rate is close to just 1%. Sorry Dave Ramsey, this one should wait. The same goes for Steph’s student loans and their mortgage, as those interest rates are going to be significantly lower than the expected rate of return on a blended investment portfolio under most circumstances. Of course, I will reevaluate all of these conclusions in each update.
I hope this illustration of dynamic cash allocation is helpful. If you have any comments or questions, please let me know.
New Disclaimer: I do not actually know a Hal and Stephanie Brown. They are purely fictional. This fact pattern is not based off of any client’s situation. It is purely fictional. Any similarities to anyone’s situation is coincidental.