For many individuals receiving a lump sum is a key turning point in their lives. When markets are uncertain, as they are today, it can be difficult to know when to put the resulting cash windfall to work. Regardless of whether you sold your business, inherited a windfall, received your pension payment or maybe won the lottery, we want you to know the best strategies to deal with the lump sum.
What is a lump sum?
A lump sum is a single payment of money, as opposed to a series of payments made over time. Most commonly, significant lump sums come from selling a business, receiving an inheritance or a pension payment.
Sale of Business
After years of building up a business, entrepreneurs may receive a large lump sum on the sale of their company, either to a private buyer or through a public listing.
A substantial inheritance may come at any age and presents many of the same dilemmas that confront an entrepreneur following the sale of his or her business. The appropriate investment strategy here will depend on the age of the individual at the time of his or her windfall, their expected spending needs over their lifetime, and their appetite for risk.
Retirement lump sum
Instead of buying an annuity on retirement, which provides a guaranteed monthly income, a retiree may also be given the option of receiving a lump sum. A lump sum comes with more freedom to invest funds and means that what remains can be passed on to future generations. But this comes at the cost of a higher degree of uncertainty regarding the return and income stream.
What do you do after receiving a lump sum?
The most important first step is to devise an investment plan that is tailored to meet your financial aspirations. But going from a plan to reality isn’t straightforward. When deciding how to put your cash to work, you have several options: should you invest right away, wait for a market pullback, or invest a bit at a time?
Let’s look at one scenario of what a 50 year old entrepreneur did when she received a lump sum after selling her business:
So how do you make sure you protect your money whilst achieving both your short-term and long-term needs?
Starting point: Build a plan using the Liquidity. Longevity. Legacy. approach
The Liquidity. Longevity. Legacy. approach is a good starting point for handling any lump sum, regardless of its origin. This framework is geared toward aligning a family’s assets with their financial objectives over generations.
Failure to plan adequately for liquidity needs can force clients to sell assets at discount prices. By assessing the family’s cash flow needs over the next two to five years, and setting aside funds to meet them, it creates a buffer between cash needs and market returns, thus reducing the risk of being forced to sell assets with high return potential at the wrong time. This strategy generally involves low-volatility assets such as short-term fixed income and cash, as well as borrowing facilities.
These assets are designed to satisfy lifetime needs. With short-term cash needs met by the Liquidity strategy, these assets can be focused on long-term growth, with an asset allocation tailored to the investor’s risk appetite and the family’s aspirations.
This strategy is assigned to improve the lives of others, both within the family and in society. In many cases, this will include cash flows lasting beyond the investor’s lifetime, including philanthropic goals and assets earmarked for future generations. Given the opportunity focus over a very long investment time horizon, this strategy has the capacity to invest in asset classes that offer an illiquidity premium, such as private equity, or investment themes that seek to profit from long-term secular trends in society or technology.
With all of this in mind, what is the best way to go from cash to being invested in the optimal portfolio?
Here are the best phase-in strategies:
Putting the entire deposit to work straight away
This can feel uncomfortable for many investors, given the risk
of investing close to a market peak. But financial theory would suggest that
putting a deposit to work straight away is often the best option, since risk
assets typically trend higher. The S&P 500 trades within 5% of a record
high 60% of the time, and only 12% of the time more than 20% below its last
These factors tell us that, on average, putting funds to work all at once will have a modest edge over strategies that phase in capital or wait for a sizable correction. The likelihood of forgoing capital appreciation—and the size of the performance drag—is significantly higher for longer phase-in time frames. And the potential market timing benefits are much lower for safer and more-diversified portfolios due to their smoother and more consistently positive return streams. On the other hand, the average cost of waiting is greater for more aggressive strategies, whose expected returns are higher.
Alternatives to an “all at once” approach
Although the “all at once” math is well and good for everyday deposits—where the law of large numbers allows investors to harness a statistical edge—the math is different for large lump sum deposits. When an investor’s deposits are fewer and more “lumpy,” the cost-benefit is shifted, and the potential risk of bad timing becomes more prominent, and there can be psychological benefits of phasing into markets.
Putting bonds to work in a lump sum, phasing stocks
Of course, with large deposits the potential cost of bad market timing is greater. Since World War II it has taken an equity-only portfolio just over two years (26 months) on average to recover from a trough back to a prior market high. This would be a distressing wait for an investor who has mistimed a large windfall investment.
The potential for such an eventuality would be mitigated by investing directly in government bonds – which are less volatile – and phasing into riskier assets – known as “dollar cost averaging.” We believe the best strategy is to establish a set schedule, and to accelerate each phase-in tranche if there is a market dip of at least 5%.
As a result, putting bonds to work in a lump sum can help to mitigate the potential opportunity cost of a phase-in strategy. In addition, if there is a chance to buy stocks during a dip, the investor’s bond holdings may rally due to a flight-to-quality, resulting in some additional capital to deploy as the investor “rebalances” into the stock allocation.
Options & structured investments
Implementing a put-writing strategy
A put-writing strategy enables investors to earn a premium by giving others the right to sell them a security or exchange-traded fund (ETF) at an agreed-upon price – typically a discount to the current market price. If the market does not fall, the option expires worthless, and the put-writer keeps the premium. If the market falls, the put-writer – who had been intending to increase exposure to equities anyway – ends up taking delivery of the stock. While this strategy is not without its drawbacks, it can mitigate the drag on returns as an investor gradually enters the market.
Buying call options
The biggest risk of any phase-in strategy is “opportunity cost,” where markets rally sharply, resulting in forgone gains when the investor eventually buys at a higher price. Call options are one way to help defray this opportunity cost.
Using structured investments
As an alternative to directly purchasing option strategies or other derivatives, some investors may be willing to fully commit their cash upfront in exchange for a structured investment that provides some combination of these strategies’ characteristics. For example, some structured investments limit upside participation in an underlying index, in exchange for downside protection, a fixed coupon payment until maturity or other features to adjust the likely distribution of returns.
For more info about the difference between an ‘all at once’ approach and ‘drip feeding’ the investment, you can read our previous article here: ‘Why time in the market is key’.
In all instances, speaking to an advisor to find out your options and make sure you have the right information on potential tax liabilities, is a good idea. Get in touch with one of our team if you would like to discuss Lump Sum investing options.