How do I calculate the liquidity constraint in an IPS?

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AcadiFi · Accepted Answer

Liquidity needs in the IPS are cash flows that must be funded from the portfolio without forced sale of risky assets. Two categories:

1. Ongoing liquidity. Year-over-year recurring needs: scheduled distributions, living expenses net of income, required charitable giving.

2. One-time or intermittent. Specific near-term planned outflows: home purchase, child's college tuition next year, tax payment due in 60 days, emergency reserve.

A common convention is to set the liquidity buffer at one year of ongoing distributions plus any near-term one-time needs. Anything further out is handled by asset-allocation ladder, not buffer.

A concrete example: Priscilla Oduya, 68, recently retired. Annual distribution need: $95,000 (after-tax) plus a confirmed $50,000 home renovation scheduled in 6 months. Tax payment of $12,000 due in 60 days.

Liquidity requirement:
- Ongoing buffer: 1 year of $95,000 = $95,000
- One-time: $50,000 renovation + $12,000 taxes = $62,000
- Total liquidity constraint: $157,000

On a $1.8M portfolio this is 8.7% — the IPS should reserve at least that in cash/short-duration instruments. The remaining $1.643M is invested per the strategic asset allocation.

Additional considerations:
- Emergency reserve: 3-6 months of living expenses if the client has no separate reserve.
- Portfolio income vs required distribution: if the portfolio generates $25K in bond interest and dividends, the net draw is $70K, reducing the ongoing buffer requirement.
- Tax timing: US clients often need quarterly estimated tax lumps — plan distributions to cover them.

CFA exam tip: always separate ongoing from one-time when writing the IPS liquidity paragraph. Auto-marked templates expect both.

How do I calculate the liquidity constraint in an IPS?

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