How Much To Keep In Cash?

Traditional advice holds that retirees should hold somewhere between two and five years worth of living expenses in cash.  This is wise advice.  You can plan for regular monthly expenses such as car insurance, your mortgage and/or property tax payment, income taxes, and even food/entertainment expenses.  One thing you can’t plan for, though, is an emergency.  That’s where your emergency fund comes one.

How Much Is Enough?

Workers with a regular paycheck can afford to take some risks here.  If something happens, they can rest assured their future income will get them back on trap (but they’d better have long term disability insurance!).  Retirees don’t have this luxury.  They have no future stream of income to help mitigate their losses.  Younger retirees are even more at risk, since their nest egg will have to last much, much longer than the typical 70-something retiree.

So what’s a young retiree to do?  How big is big enough when it comes to you emergency fund?  There are two conflicting perspectives on the issue:

1. Young Retirees Can Least Afford To Gamble – Since a 40 year old’s portfolio must obviously last a lot longer than a 70 year old’s portfolio, the 40 year old can least afford to sustain heavy losses.  This would argue for a larger emergency fund, on par with the 2-5 year recommendation, to protect against the risk of having to sell an investment at an inopportune time.
2. Young Retirees Can Always Go Back To Work – The other side of the coin is that young retirees can always go back to work.  A 40-hour work week may be a terrifying proposition to a free-spirited 45 year old retiree, but he still has it a lot better than the 75 year old retiree.  The 45 year old is presumably well-capable of working for a living.  The 75 year old?  Maybe not.  Semi-retirees will have a huge advantage here.  Since they never totally left the work force, their skills are probably a lot sharper than somebody who’s spent the last 5 years traveling for a living.  This would argue for taking on more risk and using a full- or part-time job as a backup plan.

A Third Factor…

As I’ve written before,  most young retirees invest for cash flow rather than total return because they have different goals and different criteria for success.  Cash, in most cases, is the lowest-yielding asset class, often earning negative real returns after taxes.  For this reason, I advocate young retirees holding a much smaller emergency fund than is typically recommended:  something on the order of 12-18 months’ worth of expenses seems about right.

Holding too much cash will impair your cash flow to the point of making early retirement impractical, if not downright impossible.  Going back to work may sound unappealing, but I would consider myself very fortunate to have that option.  There are also a few other alternatives such as part-time (rather than full-time) work, starting your own business (perhaps a franchise), and various passive income opportunities.  The point is, early retirees have a large capacity to take on risk.  I think it wise to take advantage of that.  It should pay off more often than not.