From the January 2013 issue of Research Magazine • Subscribe!

December 20, 2012

The Dangers of Too Much Liquidity

Limiting liquid assets, and the temptation to spend them, is a key to building long-term wealth.

Which is better, a lump sum or an annuity? A recent Texas Tech study investigated how much money people were willing to accept today to give up $500 a month from their Social Security annuity. One of the few statistically significant predictors was liquidity. But not in the direction we expected. Those who placed a large value on access to funds in times of medical need were less willing to sell their annuity.

This may be influenced by another factor strongly related to annuity valuation—whether respondents thought they were liable to spend the lump sum during the year after receiving it. Those who thought they might be tempted to spend the money wanted nothing to do with giving up an annuity.

Conventional wisdom on liquidity goes something like this: Liquidity is good because it provides ready access to cash when we experience random expenses such as a medical event, or an income shock such as the loss of employment. Households should have between three and six months of average expenses in a liquid account such as a money market savings instrument in order to be adequately prepared for a crisis. The downside of liquidity is that the investor gives up a duration premium on fixed income investments as well as a risk premium that could have been gained from investing in equities.  

Recent studies suggest that the positives and negatives of liquidity are a lot more complex. Indeed, most people actually don’t see the ready access of liquidity as a good thing.

Resisting Temptation

A mind-bending research article by Princeton economics professors Faruk Gul and Wolfgang Pesendorfer in 2001 described how resisting temptation can actually make us less happy. Building up an emergency fund creates temptation because it opens up many more spending possibilities. Once we have $30,000, we could either do nothing or we could buy a new car. It is much easier to ignore the temptation if we can’t afford it. Once we can afford it, buying it suddenly becomes an option we have to reject. Rejecting options, according to Gul and Pesendorfer, is neither easy nor pleasant. 

Harvard professor David Laibson has published a number of recent studies on how people deal with short-run temptation. Laibson sees avoiding temptation as a battle between our short-run desires and our long-run goals. In the short run we often succumb to temptations that we later regret because we weren’t willing to summon the will to resist.

We deal with temptation using an age-old technique illustrated 3,000 years ago in Homer’s Odyssey. When advised by Circe that he would be unable to resist the song of the Sirens, Odysseus had himself tied to the mast to avoid steering his ship toward disaster. Tying oneself to the mast is an example of a commitment device. We use commitment devices to avoid wrecking our long-term plans by succumbing to short-run temptations.

An annuity is a type of commitment device because it forces us to avoid the temptation presented by holding assets that could be liquidated at any time to pay for something our short-run self finds appealing. Instead of having to reject the short-run desires to buy a new RV, vacation home or classic car with our 401(k) assets, annuitization takes those options off the table. It also ensures that we will have money in the future to meet late-stage retirement goals and health expenses. 

Laibson and his co-authors were interested in estimating how much value people placed on liquidity, so they offered them a gift and gave them a few investment options. Participants could invest the money in a liquid account that earned 22% (a high enough rate that they took the decision seriously). They could also put the money into a less liquid account that earned either 21%, 22% or 23%. The illiquid options had a penalty for early withdrawals of either 10% or 20%, or did not allow early withdrawals at all. Subjects were then asked how they would allocate the gift among the purely liquid account earning 22% or the illiquid options ranging from 21-23% and having different penalties.

According to conventional wisdom, the decision is a no-brainer. Since illiquidity restricts our options, we will always choose the liquid account unless we’re willing to give up the flexibility for an extra 1%. What would you do? Maintaining liquidity increases temptation, and the cost of spending the money is the loss of a hefty 22% interest rate. Would you tie yourself to the mast to avoid the temptation of spending your liquid account? 

Most of the participants tied themselves to the mast, but only when the rope was strong enough to hold them. At the same interest rate as a liquid account, respondents allocated 39% of their money to the illiquid account when the penalty was 10%. When the early withdrawal penalty was 20%, they allocated 45%. When early withdrawal wasn’t allowed at all, they put 56% in the illiquid account.

Most people are willing to give up liquidity for no increase in extra return in order to avoid the temptation to spend. When the interest rate was one percentage point higher in the illiquid account (23% vs. 22%), they allocated most of their money to the illiquid account and put more in the accounts with higher withdrawal barriers. 

Mental Buckets

Laibson also used a trick in his experiment to help the participants place more value on saving. He called the liquid option the “freedom account” and the illiquid options the “goal accounts.” Respondents who invested in the goal accounts were also required to write down what the goal was. So respondents had to envision what they would sacrifice by yielding to temptation. This trick, a behavioral finance concept known as framing, can help us avoid temptation by assigning a label to different accounts based on their intended purpose. This allows you to convince yourself that money isn’t fungible among accounts.

Advisors can use this trick when they create an emergency fund to keep clients from spending their safety net. Joe Tombs, founder of Amicus Advisors, uses framing by placing emergency funds in an account that is viewed by clients as separate from conventional liquid accounts. “I typically will keep a large holding of cash in their investment accounts instead of their bank accounts (although we link the accounts to streamline moving the cash),” says Tombs. “That way, it doesn’t show up in their bank accounts where it might be spent frivolously. It’s in a different mental bucket—one that requires them to call us or at least to go online and move the money.”

He adds: “During the accumulation phase, we rarely recommend a large cash holding anyway. For people in the distribution phase, we hold the cash portion in their investment account and disburse their regular monthly or quarterly installments via automatic transfer and then they call in whenever they need a bump in that amount or a one-time supplemental distribution.”

Rick Miller, a financial planner in Waltham, Mass., uses a similar strategy by having clients hold liquid emergency funds in separate accounts that are not labeled for current consumption. “We suggest establishing a separate account, usually at another bank (other than the location of the primary checking account) such as ING Direct, and calling it the Emergency Fund,” says Miller. “We do find that clients like the notion of special accounts to save for vacations, estimated taxes and the like, as well as the Emergency Fund.” 

Most clients who accumulate significant wealth are used to avoiding temptation. By its nature, accumulated wealth is the end result of many decisions to save rather than spend. Clients with inherited wealth, or assets earned quickly for example through a windfall, may find maintaining a large liquid account more challenging.

Tombs has a number of clients who received legal judgments that provide instant liquidity and a strong temptation to spend. Tombs notes that “in extreme cases where people have little experience managing money, such as personal injury victims, we recommend that the cash portion of their investments be held in trust and limit their access to the account by amount or type of expenditure.” Tombs also pushes clients to place a significant amount of their judgment into a structured settlement annuity to make sure that future goals are met. 

Building Wealth

Most U.S. households accumulate wealth in illiquid investments like real estate, retirement accounts and private businesses. Many believe the illiquidity of these assets contributes to wealth creation. If the money is held in a piggy bank that prevents easy access, we tend to avoid spending it. In a study we conducted on burial insurance policies among low-income households, we found those who owned these (often costly) cash-value insurance policies accumulated more wealth than low-income households that didn’t own a cash-value policy.

Shielding assets with illiquidity is also one of the reasons why so few households incur early withdrawal penalties from retirement accounts such as IRAs and 401(k)s. Even though the penalty is relatively modest, most tie the account with an important future goal—an example of how behavioral finance can be used to improve policy. 

Advisors with an appreciation for the problems of too much liquidity can help their clients by recognizing the cost of temptation. Selecting investments with real or imagined roadblocks to short-run spending helps a client avoid steering their ship onto the rocks before they reach their goals.


Correction: An earlier version of this story incorrectly stated that an "illiquid option" should be called a "freedom account." A freedom account should be a liquid option.

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