An emergency fund for retirement? Yes

Christine Benz: Hi, I'm Christine Benz from Morningstar. Having an emergency fund is financial planning 101, but do you need a cash cushion in retirement? Joining me to discuss that topic is Judith Ward. She is a senior financial planner for T. Rowe Price.

Judy, thank you so much for being here.

Judith Ward: Thanks. It's great to be here.

Benz: Judy, you and the team at T. Rowe Price recently looked at contingency funds, cash cushions in retirement. Before we get into that, let's discuss how working folks should approach this, people pre-retirement. Do you think that standard three to six months' worth of living expenses is a safe emergency fund? Is that about what I should earmark?

Ward: Yeah, I think that's the general rule of thumb. And we at T. Rowe Price agree with that for the most part. I think if there's a single breadwinner, or your income might be sporadic or something, you might want to have a …

Benz: If you're a gig economy worker or something.

Ward: Yeah, you might have a little more. And the purpose of the emergency fund--and I always hear people talk about, oh, it's the big expense, it's, oh, you need the new roof. And to me, that's so cliché. There's a lot of things you can plan for. But I really see it as, if one of you were to lose your job, how would you make it through that period of uncertainty? I think that's the key reason for an emergency fund. It can also help with some of these larger unexpected expenses. But it's--you don't want to have to raid your retirement savings or put--you don't want to put a mortgage on a credit card, for goodness sake. So, how are you going to tide over during these periods of uncertainty? So, we think three to six months of expenses is reasonable. Like I said, maybe a little more if there's a single earner for the household or your income is disjointed.

Benz: How about if I have a high income or some really specialized career path? Should I be a little more cautious there too, maybe set aside a larger cushion?

Ward: You could, but you have to think about what are the expenses that you're going to still have to pay if you're out of work and how long might it take you to find another job. So, that's really, I think, the considerations for how much should be in your emergency fund. And you don't need to fund everything. If you're in a--there are ways that you can cut expenses, but it's like, the mortgage payment, the important payments that you want to make sure keep going. So, again, you don't have to take money out of your retirement account. So, this is money that should be set up outside of your retirement accounts. Because you really want to try to keep your retirement goals on track even during this period of uncertainty.

Benz: So, let's turn and talk about retirees and how much of a cash cushion they could think about or should think about. You have been looking at that topic. Let's talk about why they may want to run with an even larger cash cushion or contingency fund than the people who are still bringing a paycheck.

Ward: Right. So, now that you're in retirement, you don't have the paycheck anymore, you can get to your retirement account. So, it's really--the purpose I think has changed a little bit from when you were working, the whole reason is, we didn't want you to have take money out of your retirement account or use credit cards. Now, in retirement, it's more around, I call it a safety net, a contingency. A friend of mine calls it his "sleep-at-night money." It's kind of to protect you when maybe markets go down, when you do have maybe a large unexpected expense, that you have this contingency reserve. I like it especially in case of market volatility. It gives you an alternative to pull money, rather than your portfolio where in case it's all down at the same time--not that we've seen that that often--but it's just this contingency reserve. We think one to two years of expenses might be a good amount. And the reason we came to that was we looked at, again, probably a worst-case scenario, in 2008, how long did it take a portfolio to recover. And a 60-40 portfolio using just broad-based indices, it took about two years, up to two years to recover. So, you might have to draw on that for a year or two, while you let your portfolio recover. So, we think that's a reasonable amount for retirees to consider.

Benz: So, when you say one to two years' worth of expenses, am I thinking just in terms of like my portfolio withdrawals, because my expenses are going to be covered in part by Social Security, maybe a pension, right?

Ward: Yeah, that is a great point. So, it is more of what you might be drawing from your portfolio. Not necessarily all expenses. If Social Security is covering a lot of your expenses, you're still going to have your Social Security payments. If you have a defined-benefit pension, that might be covering some expenses. So, it's really to help with an alternative to drawing from your portfolio.

Benz: So, you can overdo it, though. You said that two years is probably the high end that you'd want to think about. Because there is an opportunity cost to having too much in cash, right, that will tend to underearn your long-term portfolio.

Ward: Right. Yeah. And when we're talking about this cash contingency, we're talking money market, bank account, maybe CDs, maybe ultra-short or short-term bond. So, there is an opportunity cost there for growth potential. And we think, in retirement, you could be in retirement for 20 to 30 years or longer. So, you still need that growth potential that stocks provide, maybe a more-balanced approach. So, yeah, the more money you have in cash is more money you have not working for you. So, you have to consider that as well.

Benz: So, in terms of where to hold it, if I'm retired, I guess, I should locate my cash wherever I'm pulling my withdrawals from currently. So, if I'm subject to RMDs, it goes in my IRA, is that how I would think about it?

Ward: Yeah, I would--RMDs are going to have to come out anyway.

Benz: Right.

Ward: So, you want to approach it as to, again, where the money is coming from. With RMDs you can't help but pull from there. If you're not at RMD age yet, perhaps you do want to have it kind of outside of your retirement accounts. And that's something you can work towards prior to retiring, is maybe building that up. So, yeah, you would have to look to where you're naturally kind of pulling that money.

Benz: Judy, you know I'm a believer in the bucket strategy.

Ward: Yeah, that's right.

Benz: So, this fits with it really well.

Ward: Yes.

Benz: Thank you so much for being here.