Thursday, November 3, 2011

Cash Flow And Balance Sheet Management: Part 2

Managing both never ends.

If you think the difference is just an issue for financial analysts, you are wrong. You’re wrong big time. Financial analysts may need a more detailed understanding than you do, but at least a passing understanding is probably more important to individuals.

“How can it possibly be more important for me than for a financial analyst?” you ask. Simple. Remember the statement from “Whose Future Is It?”: “The borrower is betting his or her future.” When the issue is an individual’s cash flow and balance sheet, it’s the entire enchilada that you are betting. One needs to understand the difference and have a passing understanding of how they interact. Any decision one makes with regard to money has both cash flow and balance sheet implications immediately, and those immediate implications will shape the future.

If you want an example of how easily errors are made when only the balance sheet is considered, it’s easy. Just envision the miser who dies from his or her self-denial despite the cash-generating potential of the accumulated wealth. That doesn’t seem to be the US’s problem.

Errors resulting from only focusing on cash flow are probably more prevalent. For some very current examples, see the discussion of the numerous errors people make when discussing the federal government budget. They are described in “Balanced Budget And Balance Budget Amendment: Dangerous Fiction.” This quote summarizes the problem: “The Federal government does its accounting on a cash flow basis…. That approach substantially increases the likelihood of errors – errors in each step and cumulative errors. To illustrate the risk on each step, both the initial Boehner and the Reid proposals to end the deadlock on the debt ceiling came up short when scored by CBO. For cumulative error, how have the forecasts of Medicare and Social Security faired?”

For discussions of balance sheet management that is more oriented toward the individual, see “Truth In Lending” and “Borrowing For Investment.” The first, “Truth,” addresses myths associated with borrowing for consumption. The second, “Borrowing,” introduced some balance sheet issues more directly. However, it ignored the fact that “debt carrying capacity also involves cash flow,” a point made in the discussion of a balanced budget. Consequently, it only introduced the issue. It is when cash flow and balanced sheet are viewed together that a financial plan becomes possible.

Back in “Investing Part 3: Setting the Volume,” the ability to anticipate cash requirements was introduced. It goes by many names from forecasting expenses to the often-dreaded budgeting. No matter the name used, without it a financial plan is close to impossible and balance sheet management a bit constrained.

The constraint seems to lead in self-contradictory directions. As mention before on this blog, some people only view assets as a way to transfer consumption between time periods. They ignore assets as an income-producing resource. It isn’t unusual for that approach to assets to be associated with an inability or unwillingness to try to project cash flow requirements. It’s what, for lack of a better term, might be called the “how long can I hold out on what I have” approach to balance sheet management. The result is an excessive focus on current market values (an obsession with mark-to-market accounting).

The contradiction is that if it’s just a transfer of consumption into some future period, why the heck does current market value matter? What matters is the value at the time when it will be translated back into consumption. The only explanation that seems to fit is a conclusion that if they can’t forecast their own behavior, they conclude that trying to forecast cash flow or future market values is hopeless or just too darn hard. Somehow no forecast is better than one that is uncertain. Perhaps their ego cannot accept the fact that their forecast will be wrong (unless they incorporate a margin of error). So, they find refuge in the “certainty” of current market value.

The unfortunate result is people ready to retire one year and planning to “have” to work forever the next year. Just as sad are people who have to accumulate great stores of low return assets before they can accept the risk of a long life, or, even worse, people who run out of money during old age, often late in old age.

At the other extreme are people who can forecast cash requirements, but can’t relate them to a balance sheet. If we’re giving these tendencies a name, let’s call it the “they’ll take care of it for me” approach. The approach totally ignores what is referred to as the “agency issue.” That’s a fancy term for the fact that the interests of the person abdicating responsibility and the interests of the person accepting the responsibility (the agent), aren’t the same. In fact, they conflict. The agent wants / needs the cost of fulfilling the responsibility to be high. The person who turned over responsibility wants / needs them to be low so that they don’t eat up all the returns.

Here’s the contradiction. The person who abdicated responsibility actually retained an even more daunting responsibility. They have to manage the financial manager. It really gets weird when the person who abdicated responsibility faults the manager with statements like “even I would have seen that (fill in the blank) was a bad investment,” or even weirder “any idiot should have known.” The strangest explanation is when they turn the responsibility over to a pension fund manager, an annuity manager, or a mutual fund management company because “Wall Street is a bunch of crooks.” Seems to me those people are Wall Street.

The unfortunate result is the proverbial angry old man, disappointed when he or she discovers that their manager didn’t quite fulfill their unrealistic expectations. They often resent the success of the person they entrusted with the responsibility. Let see, they entrusted the responsibility to the person on the assumption the person knew how to plan for the future. Why are they resentful when that the person planned for their own future? That very ability to plan was the selection criteria.

The people who manage financial institutions aren’t crooks. Generally, they are honest, hardworking, and reasonably bright people. Uncertainty is there whether you face it or pay someone else to face it for you. Turning over responsibility to someone else because it’s hard to address that responsibility doesn’t suddenly make it easier. If anything, it increases the likelihood of an error.

Why does it make it harder? Because you now have to know the incentives you’ve created for the manager and forecast how he or she will react to those incentives. Further, there is a high probability that you as the investor have created conflicting incentives. The best illustration of the conflicting incentives is when someone sets up a retirement account designed to generate cash flow at some future date, then evaluates account performance based on short-run changes in the accounts’ current market value.

By forcing the manager to focus on mark-to-market value, the person who set up the account has forced the manager into a situation where he or she has to ignore future cash flow implications in favor of current balance sheet impacts. The grantor of responsibility is creating a situation analogous to that of someone who doesn’t understand their cash flow objective. If the manager is forced or encouraged to ignore the objective, it isn’t surprising that they frequently fail to achieve it.

However, there is a conflict of interest that is so strong that the government has set up regulations to mitigate it and provide insurance as a backup when the regulations fail (of course governments exempt themselves from the regulations and insurance requirement). Specifically, it relates to defined benefits pensions (i.e., pensions that promise a specific payment – usually a percent of some reference salary or a dollar amount -- for life). Person covered, organization offering the pension, pension manager, regulator and especially those who appoint the regulator, employees’ representative (if not the individual) all have conflicting objectives. Now, lest this be misinterpreted, a fully-funded, well-managed defined benefits pension is a great hedge against some risks that are otherwise very difficult to manage. The problem is nobody involved has an incentive to fully fund a pension.

The easiest way around funding a pension applies equally well to any retirement plan. Just assume a high enough return on the investment. It instantly solves the problem. But, even if one recognizes that risk to retirement planning, there is a greater risk. Ignoring the volatility in asset returns is by far the greatest risk. However, volatility in asset return can be broken down into volatility in price (the balance sheet impact), and volatility in cash generated (cash flow impact).

Mistaken estimates of return volatility don’t just mess-up peoples’ retirement plans; they undermine their ability to simultaneously manage their cash flow and balance sheet. Mistaken volatility estimates obviously lead to mispriced assets. Clearly that leads to false conclusions about the balance sheet.

The other issue here is the pattern of the cash flow. Even if you knew the average return you would earn on your savings throughout retirement, you still can't know exactly how much lifetime income you will get. When you're drawing money from a portfolio, the pattern of returns, not the average, determines how long your savings will last. These uncertainties exist. You can’t make them go away; financial manager can’t, pension fund managers can’t, and the government can’t. The uncertainty is still there.

The key to addressing this uncertainty is understanding volatility in returns. No amount of knowledge, even prescience, regarding price volatility eliminates the uncertainty (unless all returns are generated through trading). Interestingly, for many assets, price volatility is harder to forecast than return volatility. The volatility of the non-price component of return is often much easier to forecast. Yet many people base their plans to provide for their cash flow requirements on price forecasts.

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