The study of various financial constraints has flourished in the 21st century, but most of the literature has been devoted to understanding constraints on business firms. Constraints have just as much importance for the finances of an individual or family, and trained financial advisors can play a key role in helping their clients understand the constraints on their own goals. This is true whether the client wants to buy a vacation home, start a business or simply plan for early retirement.
- A financial constrain is something that restricts a course of economic action, which must be accommodated instead.
- For instance, your broker may restrict you from short selling, options, or trading on margin, which limits your investable universe.
- Financial constraints are real issues that should not be confused with subjective or emotional excuses for not following a certain course of action.
- For many individuals, retirement income becomes a constraint in older age that curtails spending and consumption.
Types of Financial Constraints
Financial constraints are specific and objective obstacles rather than being general or subjective in nature. This distinguishes constraints, and the study thereof, from common excuses such as, "I don't have enough money to invest in this stock" or "I just have a hard time understanding investments." Think of it as the difference between telling someone which highway to take between Kansas City and Denver versus drawing them a road-map with specific information about speed traps, bad weather conditions or long stretches without gas stations.
For the investor, a financial constraint is any factor that restricts the amount or quality of investment options. They can be internal or external (the examples above could both be considered a form of internal constraint, such as lack of knowledge or poor cash flow). Every investor faces both internal and external constraints.
Some constraints are common sense. Each investor needs to understand his own time-horizon constraints, for example. This is equally true for a client with a five-year-old daughter, who wants to save enough money to put her through a four-year university education, and for the 50-year-old who is behind on retirement investing and wants to stop working before age 70.
All clients face tax constraints on their investments. When discussing clients' retirement goals, be specific about the negative impact of taxation on all realized gains and generated income, including after retirement. If the client wants to start a business or invest in alternatives, such as precious metals or art, be sure to highlight all of the legal and regulatory constraints. High-net-worth clients may have special interests in philanthropic organizations or travel, but each of those comes with constraints and opportunity costs.
Liquidity Risk Management
Liquidity risk management is a prime example of a field that is thoroughly studied in the business space but too infrequently applied to personal investments in a systematic way. In short, a liquidity risk is the risk that a given economic agent (e.g., individual, company or country) could temporarily run out of cash. Almost every investment involves an asset that is less liquid than cash, so the investor and his advisor have to consider how the investment limits future cash flow.
Retirement planning combines four types of financial constraints: liquidity risk, time horizon, taxes and legal/regulatory constraints. If you recommend that a 35-year-old client contribute $5,000 per year to an individual retirement account (IRA), understand that this person is effectively devoting $122,500 over the next 24.5 years to a non-liquid account. With some exceptions, your client will be unable to retrieve those assets without paying a large fee to the government.
Not spending that extra $122,500 is a constraint, and it needs to be explicitly identified as such. Your client should understand the trade-off between not spending $122,500 before retirement in order to receive more than $122,500 in post-retirement income.
Avoiding Overspending in Retirement
When Social Security was first created, the average American didn't live to age 65. Less than half of all contributors were expected to ever receive benefits from the system. Not surprisingly, private companies could offer stronger pensions in the 1940s and 1950s, when the average life expectancy was much lower.
The average life expectancy for Americans born in 2018 was approximately 78.7 years. Long life is a blessing and a constraint. Your client cannot afford to spend 10% of his retirement savings every year after 65 if he plans on living until 85. It is up to financial advisors to help their older clients avoid overspending in retirement.