Holding the right amount of cash in retirement could be the difference between you running out of money or having far more money than you will ever need.
You don’t want all your money in cash in retirement though, that would be disastrous and hopefully by now you realise you need to invest the majority of your money in real assets like global stocks.
So how much cash should you hold? Well, there is a simple formula to it and this article will explain how it works.
Why holding cash in retirement is an excellent investment strategy
When we talk about holding cash in retirement, we mean easily accessible money that you can access within a day or two. So, money that could be held in your bank account or savings account.
It needs to be money that is not exposed to any fluctuations in value as in it can’t go down. You need to know where you stand with this money.
Yes, you should still be trying to earn the best interest you can on this money, but you don’t want to lock it away for over a year as then you might not be able to access it when you need it.
To understand how much cash you should hold in retirement you need to start by understanding your next two years’ worth of spending commitments.
- What are your monthly outgoings on bills?
- How much do you need for socialising?
- Holiday plans?
- Gifts to friends and family?
Add these all up and add to it any big one-off spending commitments you have coming up. So, this could be things like:
- Work on the house.
- A big holiday.
- A planned early inheritance gift to children.
Once you have this figure you need to subtract any secure income you will receive for the next two years. You shouldn’t be including any withdrawals from savings, investments or pensions. Secure income means:
- State Pension.
- Pension annuity.
- Defined benefit pension income.
The reason we deduct secure income is because this income should carry on being paid to you for the rest of your life.
You should now have the total figure that you should be holding in cash at all times.
Let’s apply this to an example.
Richard is 68 and recently retired.
His monthly outgoings are £3,500, which over two years will be £84,000.
He also has a big holiday planned to Australia which he budgets will cost £15,000 and wants to replace the kitchen in his house at a cost of £18,000.
In total, Richard plans to spend £117,000.
Richard is currently receiving his State Pension at £815 every four weeks, so £10,600 per year and has a small defined benefit pension paying £5,400 per year.
We can deduct the two years of income (£32,000) from Richard’s required spending figure.
This leaves him needed to hold £85,000 in cash.
Why the two years?
Well, once in retirement you will be withdrawing from your pensions and investments. You will be selling units to release cash to live off. In Richard’s case in the example above. He needs to withdraw £2,167 net per month to top up his secure income and cover his regular spending.
The price of units in your pension and investments will fluctuate on a daily basis and will sometimes fall significantly during stock market crashes.
A ‘Bear Market’ starts from when the stock market closes at least 20% down from its previous high.
Taking withdrawals from your pensions and investments during a period like this means having to sell far more units than normal because the price is low but you still need the same amount of cash to cover your monthly spending. This is dangerous as remember in retirement, you have no more money going back in. You can’t top up the pot and buy more units back,
If we go back to January 1926 and look at all of the Bear Market’s in the UK since then we can see that the average length of one of these is one year and six months. Some have lasted longer and some significantly less.
So, this is why we say to hold two years’ worth of cash. Once we know we are entering a Bear Market you can stop withdrawals from your pension and investments and start to take money out of your cash fund instead. It means not having to sell so many units when the price is low and you can wait for the subsequent recovery.
Once things have recovered in the stock market and we are in a ‘Bull Market’ (the opposite of a Bear Market) you can withdraw more from investments and top up your cash buffer.
Don’t hold too much cash though
You may be thinking that if the stock market can fall so significantly and put my funds at risk why not hold all my retirement savings in cash?
Well, whilst you may think you are not losing anything by having all your money in cash, you need to remember two things:
- Your retirement could last 30 plus years and
- Prices for everything you buy and use will rise two and half times over this period if we use average inflation.
This means the purchasing power of your cash fund will dwindle over time and makes it even more certain that you will run out of money.
You need the vast chunk of your retirement savings to be growing above the rate of inflation which means investing in global stocks, the great businesses of the world.
Over history the great businesses of the world have raised their dividends alone at nearly twice the rate of inflation.
Also, whilst Bear Markets and stock price crashes are common, the market is still up around 75% of the time.
The declines are temporary, the advance is permanent.
The cash buffer just acts as the defender of humankind’s greatest investment strategy.
It’s the goalkeeper that stops you scoring an own goal.
Having a cash buffer will also ensure you have more confidence to invest more in equities as you know you always have two years’ worth of spending covered.
If you would like to stress test your retirement plans or even to get a plan in place then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the outcome you desire. We have created hundreds of happy and protected retirements over the years. This could be you too.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.