By: Scott Van Den Berg, CFP®, ChFC®, CEPA®, AIF®, CRPS®, CMFC®, AWMA®
Is a short-term, lower risk investment right for you? At the end of September 2023, various forms of cash equivalents such as money market funds, Treasury bills, Certificates of Deposit (CDs), and in many 401k accounts, the stable value fund option, currently provide yields in the 5.0% to 5.75% range.
Determining which investments to make depends on your personal situation, time horizon, risk tolerance, and goals. For example, if you have a long-term time horizon and already have enough cash set aside for emergencies and living expenses, stocks and stock-based mutual funds/ETFs may be better options for long-term growth. On the other hand, if you have a shorter time horizon or a very low tolerance for risk, then one of these cash equivalent options just might be right for you.
Let’s compare some of the more popular cash equivalents.
T-Bills (Treasury Bills):
- Nature: Treasury bills are short-term debt securities issued by the U.S. Department of the Treasury.
- Liquidity: T-bills are the most liquid of the government debt securities. Their maturity typically ranges from a few days to one year.
- Returns: T-bills do not make periodic interest payments. Instead, investors earn a return by purchasing them at a discount and receiving the full face value at maturity.
- Risk: Treasury bills are among the safest investments globally due to the full faith and credit of the U.S. government.
- Tax Considerations: Interest earned on T-bills is typically subject to income tax, if your account is taxable in nature, which can reduce your real return after accounting for taxes.
- Inflation: If the inflation rate exceeds the interest rate on your T-bill, your purchasing power could erode over time. In other words, the real (inflation-adjusted) return on your investment may be negative.
- Purpose: Treasury bills are typically used by investors seeking a safe and highly liquid short-term investment.
Money Market Funds:
- Nature: Money market funds are mutual funds that invest in short-term, highly liquid, low-risk securities such as Treasury bills, commercial paper, and certificates of deposit.
- Liquidity: Money market funds are highly liquid and can be easily converted into cash. They do not have a fixed maturity date.
- Returns: Returns are typically lower compared to CDs and Treasury bonds, but higher than regular savings or checking accounts.
- Risk: While money market funds are considered relatively low risk, they are not risk-free. There is the possibility of the fund's net asset value (NAV) dropping below $1 per share, known as "breaking the buck”, though regulations have been put in place to minimize this risk.
- Tax Considerations: Interest earned on money market funds is typically subject to income tax, if your account is taxable in nature, which can reduce your real return after accounting for taxes.
- Inflation: If the inflation rate exceeds the interest rate on your money market, your purchasing power could erode over time. In other words, the real (inflation-adjusted) return on your investment may be negative.
- Purpose: Money market funds may be a suitable option for investors who want liquidity, safety, and a potentially better return than traditional savings accounts.
CDs (Certificates of Deposit):
- Nature: CDs, considered low-risk, are fixed-income financial products offered by banks and credit unions.
- Liquidity: Typically, CDs have limited liquidity since you most often agree to “lock in” your money for a specified term (e.g., 6 months, 1 year, 5 years). For most CDs, if you want to sell before they mature, you could face stiff penalties such as forfeiting a portion of the interest earned, or in some cases, a percentage of your principal investment.
- Returns: CDs offer a fixed interest rate that is generally higher than regular savings accounts. The longer the term, typically the higher the interest rate.
- Risk: CDs are considered low risk because they are insured by the FDIC (up to $250,000 per account holder per institution), which means you won't lose your principal even if the bank fails.
- Tax Considerations: Interest earned on CDs is typically subject to income tax if your account is taxable in nature, which can reduce your real return after accounting for taxes.
- Inflation: If the inflation rate exceeds the interest rate on your CD, your purchasing power could erode over time. In other words, the real (inflation-adjusted) return on your investment may be negative.
- Purpose: CDs may be suitable for individuals who want a safe, predictable return on their savings and are willing to commit their funds for a specific period.
Stable Value Funds (401k/403b Accounts):
- Nature: Stable value funds are mutual funds that are typically limited to retirement plans such as 401(k)s and 403(b)s. These funds are designed to provide capital preservation, liquidity, and relatively stable returns, making them an attractive option for conservative investors or those looking for a low-risk component within their investment portfolio.
- Liquidity: Stable value funds are highly liquid. They do not have a fixed maturity date. However, transfers back to cash or cash equivalent securities, as opposed to other stock or sector-based mutual funds, can typically only be made under certain conditions, such as a 90 day waiting period before you can reallocate to a cash alternative.
- Returns: Historically, stable value funds have typically paid twice the interest rate of money market funds. However, this will not always be the case, especially if looking over shorter periods of time. However, they generally have substantially less volatility than bond funds.
- Risk: The holdings within stable value funds are more susceptible to changes in interest rates than money market holdings because of the longer maturities of the bonds in which they invest. This risk is mitigated by the purchase of insurance guarantees by the stable value fund that offset the loss of principal; these guarantees are available from banks and insurance carriers. Most stable value funds will purchase these contracts from three to five carriers to reduce their default risk.
- Tax Considerations: Because stable value funds are typically limited to 401(k) and 403(b) accounts, interest earned is tax-deferred if the traditional 401(K) or 403(b) option has been selected, or tax-free if the Roth 401(k) or 403(b) has been selected.
- Inflation: If the inflation rate exceeds the interest rate on your stable value fund, your purchasing power could erode over time. In other words, the real (inflation-adjusted) return on your investment may be negative.
- Purpose: If available as an option in your retirement plan, stable value funds are also a suitable option for investors who want liquidity, safety, and a potentially better return than traditional savings accounts.
In summary, each of these choices can be a good investment for the conservative investor or those with short-term investment needs. But liquidity, time horizon, and inflation protection are key considerations when deciding how much to put into any one option. At Century Management, our dedicated team of Certified Financial Planners® is here to help you make the right choice.
Century Management ("CM") is an independently registered investment adviser with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. CM is also registered as a Portfolio Manager in the Province of Ontario. All investments carry risks. Past performance is not indicative of future results. CM is not making a recommendation for or endorsing any investment strategy or particular security. This discussion is educational in nature, is not intended to be investment advice, and does not take into account specific client investment objectives. CM does not provide legal or tax advice and the information herein should not be considered legal or tax advice. A full description of our Firm’s business practices, including our Firm’s investment management services, wealth plans and advisory fees, are supplied in our Form ADV Part 2A and/or Form CRS. These Forms are available upon request by calling 512-329-0050 and are also on our website at centman.com. CM-2023-10-06