One of the essential components of stable finances is an emergency fund. This fund should be liquid and easy to draw on if needed.
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If your car breaks down and you have an emergency fund, it's a mere inconvenience to get it fixed. If you don't have an emergency fund to cover the repair costs, then you may have to turn to more expensive alternatives such as credit cards or payday loans. It is easy to accumulate credit card debt during an emergency. Once you keep a balance, you will start paying a lot of monthly interest charges.
It's a much better idea to save up for unforeseen costs in advance. Most workers should keep 3 to 6 months worth of living costs in an emergency fund, so that you stay out of debt when you incur sudden expenses.
After you retire, you will need an even bigger cash reserve. If you are drawing income from your retirement fund, you will need to keep enough money liquid to cover at least a year's worth of living expenses.
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If your retirement savings is invested in the stock market, you might want to further increase the amount of cash you keep in liquid investments. Inevitably, we will see a bear market during retirement, and it is inadvisable to sell during those times. A bear market when we are still working isn't such a bad thing because we can buy more shares while the cost is low. Once we retire, it will be very difficult to add new money to take advantage of dollar-cost averaging.
With a big cash reserve, we can ride out these bear markets and avoid selling at the trough. The average length of a bear market is around a year and a half, so two years worth of cash reserves is likely to be a prudent amount. While some bear markets last much longer than 18 months, you will still be in a better position if you can draw at least part of your retirement income from cash reserves, rather than sell stocks during a bear market.
You can deduct steady income from the amount that you need to keep in cash. For example, if your expenses during retirement are $50,000 per year and you have some stable income from a pension and Social Security totaling $25,000, you might want to keep just $25,000 per year in liquid accounts. If you determine that you need to have two years of savings in cash to ride out bear markets, you could put this $50,000 into a savings account or CD, where it is easily accessible and won't lose value.
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The target amount that you should keep in cash in retirement will vary depending on your expenses. Keeping two years of living expenses liquid after retirement should allow you to cope with most sudden expenses and ride out bear markets.
Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.
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