Chapter 6: Cash reserves & equivalents.
Much of financial planning involves money: earning it, spending it, and saving it. But before money there was barter. In the old world, Roman soldiers were often paid with sacks of salt, giving us the word "salary." In the new world, perhaps the best-known example of barter was when Peter Minuit exchanged $24 of trinkets and beads for the island of Manhattan (see page 71). Although a great deal of barter continues throughout the world, barter is inefficient when it comes to paying for goods and services. As early as 2,500 BC, precious metals began to be used throughout Egypt and Asia Minor. This naturally led to the minting of the metals into coins that facilitated the process of exchange, with the value of the coin being determined by the value of the underlying metal (e.g., pound sterling).
The American dollar owes its name to a silver coin called the Joachimsthaler that was first minted in Bohemia in 1519. Widely circulated throughout Europe, in England it became known as the dollar. In the United States paper money first appeared when it was issued in varying denominations by the colonies. To finance the American Revolution, the Continental Congress issued notes that were declared to be redeemable in either gold or silver coins, but these notes eventually became virtually worthless due to the lack of sufficient gold and silver reserves. Although the federal government first minted silver "dollars" in 1794, it was not until 1863 that a uniform currency was established that replaced the paper money that had previously been issued by local banks. Today, circulating currency, both paper and coin, is no longer backed by either gold or silver reserves, but rather by the full faith and credit of the United States.
Traditionally, there have been three basic forms of money: currency, coins, and checks drawn on banks and other financial firms. To these should be added credit cards, debit cards, and electronic payments (both preauthorized and remote). Over the past ten years there has been a continuing shift away from cash and checks to the use of electronic payment by debit cards (both PIN and signature based). This shift is expected to continue in the future. (1)
Savings generally involves shorter-term goals with an emphasis upon liquidity and safety of principal. In contrast, investing involves longer-term goals with lower liquidity and less safety of principal. For example, funds are saved in short-term interest-bearing debt instruments such as certificates of deposit or United States Treasury bills (created and transferred in the money market); whereas, funds are invested in longer-term debt or equity such as corporate bonds or common stocks (created and traded in the capital markets). (2) Unfortunately, in practice the terms are often used interchangeably. (3)
Checking Accounts. Also known as regular checking, these are demand accounts that allow the depositor to issue checks directing the financial institution to pay the party listed on the check a specific sum of money. The credit union version of a checking account is known as a share draft account. Provided there are sufficient funds in the account, there are no limitations on the withdrawal. A regular checking account pays no interest on the account balance. Service charges may be applied, but are often waived if a minimum account balance is maintained or the account holder is over a certain age (the so-called "senior" account). Both automated teller machines (ATMs) and debit cards have become very popular ways of accessing funds in checking accounts (see page 88).
NOW Accounts. In contrast to regular checking accounts, the NOW (negotiated order of withdrawal) account pays interest on account balances. Many other institution-specific names are used to describe these accounts (e.g., "Checkplus Account"). Although all savings account interest rate ceilings and minimum balance requirements at commercial banks and savings institutions were removed in 1986, most financial institutions impose their own minimum balance limits for interest to be credited, often between $500 and $1,000. Interest is credited at whatever rate is set by the institution and is typically increased (tiered) if larger balances are maintained (e.g., amounts over $2,500). Since fees will offset interest earned, evaluation of a particular account should include determining exactly what, if any, monthly or other fees are charged. Provided a minimum balance is maintained, monthly fees are often waived. The dividend bearing share draft account is the credit union version of a NOW account.
Super NOW Accounts. These are NOW accounts that are generally less restrictive than Money Market Deposit Accounts (MMDAs). Interest rates are usually higher than NOW accounts, but less than MMDAs. Tiered interest rates are usually offered. Some accounts charge per item processing fees for checks or deposits, some accounts do not impose these fees, and still other accounts waive these fees provided a minimum balance is maintained.
Savings Accounts. These accounts, also referred to as passbook accounts, are considered the most basic of bank savings vehicles. The term statement account is often used in reference to savings accounts that record transactions by computer and provide either monthly or quarterly statements in lieu of passbook entries. In contrast to demand deposits, or checking accounts, savings accounts are also referred to as time deposits, since the funds are expected to remain on deposit for longer periods. In fact, many accounts stipulate that depositors may be required to wait a stated number of days before receiving payment. However, this requirement is often waived. While funds in a savings account are both safe and liquid, the rates paid on savings accounts are typically the lowest rates offered. Higher, or tiered, rates of interest are usually paid on larger account balances or for time deposits.
Money Market Mutual Funds (MMMF). Also referred to as Money Market Funds, these funds, issued by investment companies and insurance companies, are handled by mutual fund managers. Shares are purchased at a fixed price of $1 each and form a pool of money that is used to purchase short-term and high-quality debt obligations of government entities, commercial banks, and corporations (e.g., Treasury bills, bank certificates of deposit, and corporate commercial paper). MMMFs are sold as no load funds (i.e., no sales commission), but management fees are charged. Although earnings are technically dividends, they are taxed as interest income. Because the securities purchased are of very high denominations, MMMFs are able to obtain the highest rates available on the market. The interest rates change daily due to the fluctuating nature of the funds portfolio of debts instruments. The minimum initial investment and check writing privileges vary from one account to another. Typically, checks must be for a minimum amount varying from $250 to $500. Although not insured by the FDIC, if purchased from a brokerage firm MMMFs are considered securities and are insured against the bankruptcy of the firm by the Securities Investor Protection Corporation (SIPC); but they are not insured against a loss stemming from the underlying investments. However, because of their short-term nature and high quality, most experts regard them about as safe as commercial paper (commercial paper is unsecured, short-term debt instruments issued by banks and corporations in order to meet immediate cash needs). See also, page 174.
Money Market Deposit Accounts (MMDA). These accounts, also referred to as Money Market Accounts, were developed by financial institutions in order to compete against the Money Market Mutual Funds (MMMF) offered by investment and insurance companies. Interest is market-based, meaning that the rate will vary from week to week. Although the interest rates are generally lower than those available with a MMMF, they offer two advantages not enjoyed by the MMMF; the convenience of a local bank or savings association and the safety of being federally insured (normally up to $100,000, but temporarily increased to $250,000 per depositor until December 31, 2013, see page 55). A minimum balance is required, and withdrawals by check or electronic transfer are usually very limited in number, with fees charged for any excess number of withdrawals (e.g., more than 3 per month). Because of these fees, MMDAs are more in the nature of savings accounts than checking accounts.
Certificates Of Deposit (CD). Certificates of deposit are issued by commercial banks, savings and loan associations, savings banks, and credit unions. The most common maturity periods range from three months to five years. Because funds are being committed for a longer period of time, the rate of return earned on CDs is typically higher than those offered on savings accounts and money market instruments. However, if the funds are withdrawn prior to maturity, a penalty in the form of forfeited | interest is assessed (e.g., three months interest). Tiered rates are typically offered, with higher rates for longer terms and larger amounts. Because rates can differ substantially from one region of the country to another, it is wise to shop around for the best rate. Higher yields can also be obtained from brokered CDs. These are larger denomination bank CDs ($1,000 and up) that are purchased through brokers who shop nationally for the highest available rates. The bank pays commissions for brokered CDs. Unlike the typical CD, the funds in brokered CDs can often be accessed early and without a bank-imposed penalty by having a broker sell them in secondary markets. However, rising interest rates will depress the value of a fixed-rate CD. Laddering can be an effective way of providing some protection against falling interest rates (see page 26). Although the rates are typically fixed, there are hybrid CDs that offer variable rates tied to a specific market index (e.g., the S&P 500). Because the frequency with which interest is compounded is an important determinant of a CD's return, it is important to determine the yield, not just the interest rate (see page 87). While the vast majority of CDs are issued by institutions insured by the FDIC, it is always important to verify that a CD is federally insured.
Current CD rates by locale, maturity, and size are available at: www.bankrate.com/cd.aspx.
FDIC insured banks can be looked up by going to: www.fdic.gov/ deposit/index.html.
Asset Management Accounts (AMA). These accounts might be better named "central asset accounts," in that the financial institution is not actually managing the depositor's assets, but rather acting as a central depository and agent who acts upon the directions of the depositor. They were begun as bank-like services offered by large brokerage firms and mutual funds, but are now also offered by insurance companies and larger banks. They are intended to foster a consolidation of both banking and investing services into one relationship. AMAs are opened with a minimum deposit of cash or securities, offer different levels of service, and charge varying annual and transaction fees. They typically offer unlimited free checking, purchase and safekeeping of securities, debit and credit cards, access to automatic teller machines (ATM), direct deposit, automatic "borrowing" and overdraft coverage, online access to account information, bill-payment services, and advice from financial advisors. A distinguishing feature of AMAs is the automatic daily, or weekly, "sweep" of excess balances into a savings account paying interest at higher money market rates. Another very attractive feature is the monthly and year-end statement that summarizes all account transactions, often in a format that facilitates the accounting necessary for filing of income tax returns. The extension of credit in AMAs is often in the form of a margin account, with the underlying securities serving as collateral for any credit extended. Unlike a bank loan, a substantial decline in the market price of these securities could trigger a margin call (see page 152).
Treasury Bills. See page 111.
Zero-Coupon Treasuries. Also known as STRIPS, see page 113.
ANNUAL PERCENTAGE YIELD (APY)
This is the effective, or true, annual rate of return earned in an interest-bearing account or instrument, expressed as a percentage. It takes into consideration the effect of compounding. When the APY is higher than the declared interest rate, the interest is compounded (i.e., interest is being paid on interest). For example, if $1,000 placed in a CD paying 5% interest (compounded monthly) earns $51.16 during the period April 1 to the following March 31, the APY is 5.116%. If interest were compounded quarterly, the APY would be 5.095% and the interest earned would be $50.95. If the interest were not compounded, the interest earned would be only $50.00 (i.e., simple versus compounded interest). See also, The Magic Of Compound Interest, page 71.
PAYMENT CARDS (AKA PLASTIC)
Credit Cards. Credit cards generally include any card that is repeatedly used to borrow money or buy goods and services on credit. They are issued by banks, savings and loans, retail stores, and other businesses. Included are bank cards issued by banks and other financial institutions, prestige cards providing a high limit of credit and other benefits, affinity cards issued to groups of individuals with a common bond or tie, retail credit cards accepted only by the issuing retail establishment, and travel and entertainment cards that typically require payment of the entire balance when billed. Provided balances are paid in full as billed, they offer an attractive way of making purchases (and taking advantage of the float between time of purchase and time of payment). When balances are not paid in full, high rates of interest are charged. In 2009, the annual average finance rate charged by credit card plans was 13.40%.4 In 2007, over 46% of all United States families carried a balance on their credit card with a median debt of $3,000.5 In contrast, a charge card is also used for making payments, but charges must be paid in full when the statement is received.
Debit Cards. The debit card may resemble a credit card in appearance, but functions more like a checking account (it is also referred to as a "check card"). When a purchase is made, the transaction is immediately deducted from the cardholder's checking account. Because the debit card is machine-readable, funds can generally be withdrawn using automated teller machines (ATMs). Compared to the credit card, the debit card does have certain disadvantages. Whereas a credit card allows the unsatisfied purchaser to withhold payment, a debit card does not provide the right of charge-back, by which the holder can refuse to pay a questionable charge (i.e., the money is already out of the account). Also, unlike the credit card, a debit card does not have any float. And finally, contrary to popular belief, under some debit card agreements banks will process debit card charges made against insufficient account balances. The resulting overdraft charges can be substantial.
ELECTRONIC FUNDS TRANSFER (EFT)
Also referred to as the electronic funds transfer system (EFTS), this is the transfer of funds electronically rather than by check or cash. Application of this technology to consumer transactions includes Automated Teller Machines (ATMs) found in banks and other convenient locations, Point of Sale Terminals (POS) used in retail establishments, preauthorized payments of mortgages and other recurring bills, automatic deposits of employee paychecks, telephone transfer systems, and internet banking services using personal computers. The Federal Reserve's Fedwire system and automated clearinghouses (ACHs) are both part of the EFT system.
The method of ownership of property, including savings and investment vehicles, can have substantial consequences for the account holders.
Joint Ownership With Rights Of Survivorship. When an account is established in joint ownership with rights of survivorship, upon the death of one owner the surviving joint owner immediately takes full ownership of the account without the need for probate of the deceased's will or to resort to state intestacy statues. Although joint ownership is typically established between husband and wife, two or more related and unrelated persons can also effectively use it. Each joint tenant has an equal and undivided interest in the entire property. Any co-owner of jointly held property may use, withdraw, sell, or give away the property interest without the consent of the other owner(s). The entire property interest is exposed to creditor claims of any co-owner.
Tenancy In Common. Under this form of joint tenancy each co-owner has a fractional, divisible interest in the property (i.e., it is the opposite of joint tenancy with rights of survivorship). Upon the death of a co-owner, his fractional interest is probate property and passes by will or by state intestacy laws. Each surviving co-tenant retains his proportionate interest in the property.
Tenancy By The Entirety. This is a form of joint tenancy that can only exist between husband and wife. While some states do not recognize tenancy by the entirety, others may place restrictions as to the type of property that can be so titled (e.g., limited real property). Unlike joint ownership with rights of survivorship, both tenants in a tenancy by the entirety must agree to a transfer of the property interest.
Donald F. Cady, J.D., LL.M., CLU
(1) Source of data for chart of in-store purchases is New US Consumer Payment Preferences Study, Payment News, October 6, 2008 (ww.paymentsnews.conV2008/10/new-us-consumer.html).
(2) See George E. Rejda and Michael J. McNamara, Personal Financial Planning, (Reading, Massachusetts: Addison-Wesley, 1998), p. 76.
(3) See Robert J. Garner et al., Ernst & Young's Personal Financial Planning Guide, (New York: John Wiley & Sons, 2002), p. 63.
(4) Source of credit card rates is Statistical Abstract of the United States, 2011, Table 1189. See www.census.gov/ prod/2011pubs/11statab/banking.pdf.
(5) Source of debt information is Statistical Abstract of the United States, 2011, Table 1171. See www.census.gov prod/2011pubs/11statab/banking.pdf.
In-Store Purchases 1999 2008 Debit 21% 39% Cash 39% 29% Check 18% 8% Other 22% 24% Note: Table made from bar graph.
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|Title Annotation:||2011 FIELD GUIDE TO FINANCIAL PLANNING|
|Author:||Cady, Donald F.|
|Publication:||Field Guide to Financial Planning|
|Date:||Jan 1, 2011|
|Previous Article:||Chapter 5: Time value analysis.|
|Next Article:||Chapter 7: Bonds.|