Liquidity needs and life expenses

I believe this one was lamented on like million times but let’s go again as no one provided clear answer.

When are life expenses included in liqudity needs? sometimes I see they are and sometimes are not and sometimes are netted with after tax income. And some times the proposed answer is that expenses are going to be met with_____ (insert whatever, wage, portfolio, pension benefits etc.)

I was allways led by logic that if the expense is one-off (e.g. education, buying house etc.) than it certainly is a liqudity need. I also understood that if expense exceeds the after tax income, than it should also be a liquidity requirement because it will need to be funded from the inv. portfolio (if other sources unavailable)

So, does anyone have some universal answer on this topic?

Much appreciated!

Greetings friend! Here was my approach for L3 regarding liquidity needs/constraint. If this doesn’t answer your question, let me know and either I or someone smarter can try to elaborate further.

When talking about someone’s “liquidity constraint” for private wealth types of questions, focus on all the cash outflows/needs happening WITHIN the first year (first 12 months). Boom - those are your liquidity constraint components. First 12 months = liquidity stuff. Even if they recur in later years, the first year amount = liquidity… and the remaining recurring amounts then, separately, become part of the IPS return objective calculation.

Any remaining, recurring or multi-year outflows, beyond the first 12 months, are incorporated into the portfolio’s return objective, they are not part of the liquidity constraint. The “first 12 month” liquidity constraint amount is then subtracted from the person’s available asset base… and the remaining assets are used in the denominator for IPS portfolio return calculation purposes. Remember that any shortfalls not met by portfolio return must be paid out from the portfolio, further reducing its asset base over time in the denominator.

So in a given practice vignette sort of scenario I saw repeatedly in preparation for L3, they would sprinkle cash inflows and outflows throughout a problem vignette and ask you to identify the liquidity constraint. The cash amounts required to cover the first year’s expenses/costs/etc.are the liquidity constraint you need to identify (at least in all the practice problems I encountered).

They may simply skip asking about the liquidity constraint and ask you to identify the IPS portfolio return objective, and see if you confuse liquidity with the return objective. In this case, just remember that the “month 0-12” costs/expenses do NOT comprise part of the numerator for that return objective equation. They are instead subtracted (netted) from the denominator because they are immediate liquidity needs, not part of the portfolio return objective over future years. Liquidity constraint components are, from the start, netted out from the portfolio’s available asset base, then that remaining asset base is used in the denominator for the IPS return objective calculation. The costs/needs/recurring expenses above and beyond month 12 are typically the numerator for the return objective calculation. The portfolio’s available assets (after subtracting the 12-month liquidity needs) comprise the denominator for that equation. At least that’s how I approached it.

So when you see liquidity needs netted against portfolio income, it most likely means you are talking beyond the first 12 months and you are looking at calculating the portfolio return objective for the IPS. If you are, on the other hand, asked to summarize or identify the liquidity constraint, you are typically summing up all the first 12-month spending costs/needs and providing that answer as the liquidity constraint figure.

Cheers - good luck on your exam - you got this :+1:

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Hey Grey! Thanks as usual, very practical answer. I must have somehow missed this first year thing - this was the key to my confusion.

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