The Federal Reserve’s response to the COVID-19 pandemic has pushed interest rates to historic lows over the past year.
Changes to the Fed funds target rate and an extensive bond-buying program have driven down rates both at the short and long end of the yield curve. The 10-year Treasury, with a yield that had hovered around 1%, has led to the lowest mortgage rates in memory. A return of the Fed funds overnight rate to a target range of 0 to 25 basis points — a level not seen since the financial crisis — has caused most banks and brokerage firms to cut the rate they pay on cash to as little as 0.01%.
With the Fed targeting an inflation rate of 2%, and with Chairman Jerome Powell’s stated willingness to let inflation exceed that level for a while to make up for past misses, this effectively means that clients sitting on cash are earning a negative real return. And with the average high net worth household keeping 22.1% of its assets in cash, underearning on this asset class can lead to a material drag on overall real returns.
Where are we now?
Historically, financial advisors relied on money market funds to manage idle cash that remains in client portfolios. In the current rate environment, this is no longer a good option for clients. The average government MMF is yielding just 0.02%, so financial advisors who are still using MMFs as a tool for client cash may be relying on outdated advice. Similarly, most brokerage sweeps pay just 0.01%, also not an attractive option. Even the average bank savings accounts offer a paltry 0.05%, according to the FDIC. Simply put, MMFs and regular savings accounts are no longer delivering a compelling yield. A better solution is needed to keep clients on track.
Broker-dealers aren’t faring much better.
Historically, broker-dealers have made the majority of their profit by putting clients in cash sweep accounts that tend to pay almost nothing, lending out the funds at higher rates, and pocketing the spread for themselves. This little-known fact makes stocks and bonds the red herring of the securities industry — most people assume that brokerages make their money from trading commissions, but, in fact, the majority of their profit is earned from knowingly paying clients too little on their cash.
With yields lower and spreads on cash depressed, they’re still profiting from this practice, but not by nearly as much. It’s possible that a prolonged low-rate environment, coupled with recent penalties from the Securities and Exchange Commission for wealth management firms who haven’t put their clients’ interests first, could lead broker-dealers to re-evaluate whether they ought to make available to their clients better, fiduciary-focused options for cash. After all, cash is the beginning of every wealth management relationship as it is the asset that is safe and liquid — and it is often the case that investment relationships begin when clients determine that they have excess cash that could be better invested for the long-term.
Both monetary and fiscal policy must also be considered.
With the pace at which the U.S. government is printing money, inflation seems all but inevitable. Our national debt has risen by more than 40% in the past four years, and as we begin to recover from the pandemic, inflation could become more apparent in consumer prices.
It is also essential to keep in mind that those who have been fortunate enough to save during the last 12 months are sitting on cash and will be looking to spend or invest it once lockdown protocols ease up. Against that backdrop, cash that’s earning 1 or 2 basis points in a brokerage sweep or MMF is actually losing value each year.
Where do we go from here?
Now would seem to be an opportune time for financial advisors to reconsider how they are talking to their clients about cash.
Many registered investment advisors, who are bound by a fiduciary standard, are beginning to treat cash like any other asset class and are looking to maximize returns for clients.
One of the simplest ways to do this is to turn to more innovative solutions to manage client cash that put clients’ interests first. Run-of-the-mill savings accounts at online banks yield up to 0.50%, while one new innovative approach leverages technology to deliver preferential yields of up to 0.75% on same-day liquid, FDIC-insured deposits, held directly in the clients’ own name.
It’s no wonder that leading advisor tools such as Orion, Envestnet | MoneyGuide, Morningstar, and Redtail are integrating with better cash solutions that can help clients earn more on cash in their own FDIC-insured accounts.
As advisors seek to find yield for their clients, it may also be appropriate to look at less conventional yield-producing assets that may be less correlated with the market, such as produce anticipation loans, to help clients pick up extra yield.
A barbell strategy of cash plus longer-dated higher-risk assets can help clients pick up yield without sacrificing liquidity.
Many investors have also been seeking yield from dividends on the S&P 500, a trade that worked well in recent years since it offers a 2% yield with plenty of liquidity and a built-in inflation hedge.
However, anything other than cash in a client’s bank account adds risk. Looking at the risk-reward continuum across fixed-income instruments, you’d have to go nearly 10 years out on the Treasury curve before you could match the yield available in FDIC-insured savings accounts.
Now is an opportune time for advisors to engage with their clients on the topic of cash and deliver better returns. You just need to know where to look.