Liquidity refers to the ability of an asset to be sold quickly at the asset’s market price, without affecting the price of the asset.
All assets have a degree of liquidity. Nonfinancial assets such as real estate, paintings, rare books, etc., are considered to be illiquid. Financial assets such as cash and securities typically have a higher degree of liquidity, but the liquidity of these assets can vary widely.
For the remainder of this article, the liquidity of financial assets – including those used for retirement planning – will be our focus. We will also discuss why liquidity should be a factor in retirement planning.
What Determines a Financial Asset’s Liquidity?
The liquidity of a financial asset may be determined by the product design, or how the market for the asset works.
Mutual fund shares and annuities with back-end loads are illiquid by design; the companies who issue these products impose a sales charge if the investment is redeemed before a certain number of years elapses.
On the other hand, there is no restriction keeping the holder of a long-term bond from selling it; however, if interest rates have risen since the bond was issued, the bondholder may not be able to find a buyer who will pay him what the bond is worth to him.
Liquidity Levels in Financial Assets
Without a doubt, cash and cash equivalents are the most liquid financial assets. As a recognized store of value and a medium of exchange, cash can always be disposed of easily.
Common stocks issued by large, established companies are another liquid asset. The bid and ask spreads on these “blue-chip” shares are usually very slim, meaning they are very easy to sell quickly at their market price.
As mentioned previously, some mutual fund shares – particularly those with back-end loads – can be illiquid. If liquidity is a concern when investing in a mutual fund, C-shares may be a better option. They tend to be fully liquid after only a year or two.
On the other end of the spectrum, hedge fund investments are an example of a highly illiquid asset. Not only can it take a long time to realize a profit (or break even) in a hedge fund, but the fund manager can actually deny investors the ability to sell their shares at his discretion. For this reason, only accredited investors are allowed to invest in these highly speculative ventures.
Liquidity in Retirement Planning
When investing for retirement planning, liquidity is a factor that should be considered. In the years leading up to retirement, you are focused on growing your savings – not using them – so it really may not matter if your retirement assets are liquid or not.
As you approach retirement, however, this will change. In retirement, you shift from growing your financial assets to relying on them for living expenses. Because you will no longer be working, the burden will be on your investment portfolio to provide money for housing, automobiles, healthcare, and other things. That will be hard to do with assets that are not liquid. Make sure to think about liquidity as you approach retirement.