Cash flow is one of the first topics I like to cover when working with new financial planning clients. Cash flow is so fundamental to the rest of your household finances that it’s really helpful to understand how much money is coming in every month and how much is going out. With this in place we can begin to wrap our heads around concepts like your capacity to take risk, disability insurance needs, and other components of a typical financial plan.
We can also use this information to determine how big your cash reserve should be. There are many different names for a cash reserve: cash buffer, cash safety net, emergency fund, and so on. Regardless of what you might call it, the objective is to keep enough cash on hand so that no matter what happens in your life, you don’t need to sell investments at an inconvenient time (i.e. during corrections or market crashes).
The easiest way to view your cash reserve is as a function of monthly living expenses. Simply multiply your monthly living expenses by the number of months you feel comfortable with and voila! That’s how big your cash reserve should be.
During your “accumulation” or working years, most financial planners recommend a cash reserve of somewhere between 6 and 24 months’ worth of living expenses. Where you fall on that spectrum depends on a several different factors:
- Your capacity and willingness to take risk
- How many incomes you have in your household
- How consistent your income is
- How many dependents rely on your income
- What your disability insurance situation looks like
In retirement the situation is quite a bit different. You’ve already amassed the amount you need to quit working, and are obviously not concerned with the possibility of being laid off. Instead, the biggest issue is avoiding having to sell assets at an inconvenient time.
It’s a challenging line to walk. You want to keep enough cash on hand to cover unexpected expenses and avoid selling stocks in periods of market turmoil. But you also don’t want to keep more in cash than you need to. Keeping too much is a drag on your portfolio, and inflation will slowly eat it away over time. The right amount of cash for you in retirement depends on a different set of factors, which I’ll cover in this post.
1) How Much of Your Income is Coming from Guaranteed Sources
The first thing I’d suggest taking into consideration is what portion of your retirement income will be coming from guaranteed sources. If you have your monthly living expenses 100% covered between a monthly pension and Social Security benefits, you don’t need as large a safety net. On the other hand if you’re paying retirement living expenses solely from withdrawals from your savings & investment accounts, I’d suggest keeping more cash on hand for a rainy day.
Back to the underlying theme here, you don’t want to sell assets at an inconvenient time. Liquidating investments at depressed prices during a market correction or crash is the absolute worst option. You have a much better chance at avoiding that scenario when more of your living expenses are coming from guaranteed sources. This doesn’t account for unexpected expenses that might come up, but is one factor to consider.
That said, even if 100% of your living expenses are coming from guaranteed sources you still need some kind of safety net in place to cover unexpected expenses. Unexpected medical expenses & home maintenance costs tend to come up from time to time.
2) How Much Risk You’re Taking in Your Portfolio
Your asset allocation should also be taken into consideration. The more you have in stocks, the more your portfolio will be impacted by market volatility, and therefore the more you should keep in cash. Pretty logical, no?
The other way to look at this factor is that bonds, especially those issued by the U.S. government, are not that dissimilar from cash. We shouldn’t confuse bonds for cash of course, but they live in portfolios to provide diversification and a ballast when stock markets correct. More bonds in your portfolio means less need for extra cash on hand.
3) What Types of Accounts Your Retirement Savings Are In
The types of accounts your retirement savings are in warrant consideration too. If you’ve exclusively used Roth accounts to save for retirement, you probably don’t need to keep as much cash on hand since distributions won’t have any tax impact. On the other hand if all your savings are in a 401(k) or traditional IRA, you may want to play it safe with your cash reserve. For example, someone in a 24% marginal bracket (who’s keeping their cash reserve in the tax deferred account) may want to “gross up” their safety net. A $100,000 reserve should probably be raised to $131,578 ($100k / 1-24%). That way they have $100k in after tax cash available. For those of you with the bulk of your savings in taxable accounts, I’d take unrealized gains into consideration here too.
4) Your Capacity & Willingness to Take Risk
And, like all things financial, the right amount of cash to keep on hand depends on your capacity & willingness to take risk. If it feels really good to know that you have 18 months’ worth of living expenses sitting in the bank account in case you need it, 18 months could be the right amount for you. On the other hand, if the thought of inflation eating away at the purchasing power of your cash reserve sticks in your craw, you may not need as much. Either way, take your comfort level and ability to take risk into account.
All in all, I’ve seen cash reserves that run the gamut of sizes. Some retirees are comfortable with as little as 3 months’ of living expenses on hand, while others feel like they need 36 full months available at any given time. Wherever you fall on this spectrum, make sure your cash plan can accommodate a market correction or crash.
What do you think?
How much cash are you comfortable with? Is three years’ worth too much?