How Much Cash Should You Keep in Retirement?
Cash Isn't Really the Question
One of the most common debates in retirement planning is how much money a retiree should keep in cash. My answer is usually: probably less than you think.
I don't generally want retirees sitting on five years of expenses in cash. I prefer to think about how much money we're likely to need from the portfolio over the next several years and position that money outside of equities, generally using short-term fixed income for those near-term income needs.
That's an important distinction. The goal isn't to pile up cash. The goal is to avoid depending on the stock market every time you need a distribution.
Start With the Gap, Not Your Total Spending
Suppose a retired couple spends $120,000 a year. They receive $65,000 from Social Security and another $15,000 from a pension. Their investments don't need to produce $120,000. They need to produce $40,000.
That's the number I care about when thinking about how much of the portfolio should be positioned for near-term distributions. Now consider another couple spending the same $120,000 but receiving only $30,000 from Social Security and no pension. Their portfolio needs to provide $90,000.
Those two couples shouldn't necessarily have the same amount set aside for near-term spending simply because their portfolios happen to be the same size. The portfolio size might be identical. The job of the portfolio isn't.
I Generally Like About Five Years Outside of Equities
For many retirees, I like having roughly five years of anticipated portfolio withdrawals outside of equities. Notice I didn't say five years of expenses in cash. Those are two very different things.
If you're spending $120,000 but Social Security and pensions cover $80,000, the portfolio needs to provide approximately $40,000. Five years of anticipated withdrawals would be around $200,000-not $600,000.
I generally use short-term fixed income for those near-term income needs rather than simply leaving a large amount sitting in cash. The objective isn't to avoid investing the money. It's to have the money we're likely to need over the next several years invested differently from the money we're counting on for long-term growth.
Why Five Years?
Five years isn't a magical number. It's a planning framework.
Stock-market declines are inevitable. Some are short. Others take considerably longer to work through. What I don't want is a retiree becoming a forced seller simply because the market happens to be down when money is needed.
Imagine you retire with $2 million and immediately experience a major bear market. Stocks fall 30%. If essentially everything is invested in equities and you need $80,000 from the portfolio that year, you may have to sell stocks after they've fallen substantially to fund your retirement spending.
Now imagine you entered that same decline knowing that several years of anticipated withdrawals were already positioned in short-term fixed income. The stock market decline still isn't fun. But it doesn't have to dictate how you're going to pay your bills next month. That's the point.
Short-Term Fixed Income and Stocks Have Different Jobs
This is where people can get frustrated during strong markets. Stocks go up 20%, while the short-term fixed-income portion of the portfolio earns considerably less. Suddenly the conservative part of the portfolio looks like a mistake.
It isn't. Different investments have different jobs.
The growth portion of the portfolio is there to provide long-term growth and help protect against inflation over a retirement that could last 25 or 30 years. The short-term fixed-income portion is there to help provide near-term distributions without requiring us to sell stocks during a bad market.
Judging the two solely by which one had the highest return last year misses the reason they're there in the first place.
But You Can Absolutely Get Too Conservative
The other side of this is just as important. I've seen retirees become so concerned about losing money that they position enormous amounts of their portfolio conservatively for years. It feels safe because the account doesn't bounce around as much.
But there is another risk that isn't displayed in red numbers on your statement: inflation. Someone retiring at 62 or 65 isn't investing for the next three years. Some of that money may not be needed for another 20 or 30 years.
Keeping money you expect to spend next year in short-term fixed income makes sense to me. Keeping money you may not need until you're 85 in short-term fixed income simply because you've retired is a very different decision.
That's why I like separating the portfolio by when the money is likely to be needed. Near-term distributions can be supported by short-term fixed income. Longer-term money can remain invested for growth.
The Five-Year Amount Should Move
Suppose you need $50,000 a year from your portfolio and we start with approximately $250,000 positioned outside of equities for those anticipated withdrawals. A year later, you've taken $50,000 in distributions.
Do we automatically sell $50,000 of stocks to refill it? Not necessarily.
If stocks have had a strong year, that can be a good opportunity to rebalance. Some of the gains from the growth side can be moved into the short-term fixed-income side, replenishing future distributions. But if stocks have fallen substantially, I'd rather have the flexibility not to sell them simply because another year has passed.
That's one of the primary reasons the runway exists. We don't know what the stock market will do next year. We can control whether we're forced to react to it.
Social Security Can Change the Number
Your income needs from the portfolio can also change during retirement. Maybe you retire at 63 but plan to wait until 70 to claim Social Security. For those first seven years, the portfolio may need to provide considerably more income.
Once Social Security begins, the amount needed from investments falls. The same thing can happen when a pension begins, a mortgage gets paid off, a second home is sold or spending naturally declines later in retirement.
That's why I prefer calculating the actual income gap rather than saying every retiree should have a certain percentage of the portfolio in cash, bonds or stocks. Percentages don't know what your life costs.
Big Purchases Need Their Own Money
There's another category I would separate from normal retirement spending. If you're planning to buy a $100,000 boat next year, remodel the house for $150,000 or give a child $75,000 for a down payment, that's not your normal retirement paycheck. It's a known expense.
Money you know you're going to spend in the near future generally shouldn't depend on whether the stock market happens to be up when the bill arrives. That may mean temporarily increasing the amount positioned in short-term fixed income beyond what your normal retirement-income strategy would require.
Again, the money has a job.
What About Actual Cash?
Of course retirees still need some actual cash. You need money in checking for normal bills and enough liquidity to handle the things life throws at you. The air conditioner dies. A car needs replacing. There's a large medical expense. The roof starts leaking.
But I don't think that means a retiree necessarily needs hundreds of thousands of dollars sitting in a bank account on top of a properly structured retirement portfolio. If you already have substantial short-term fixed income available to fund several years of anticipated distributions, you have another source of liquidity when life doesn't cooperate.
The important thing is knowing where the money would come from before you need it.
The Runway Can Make It Easier to Stay Invested
This may be the biggest benefit of the entire strategy. The best investment portfolio in the world doesn't help much if you abandon it during the next bear market.
It's easy to say you'll stay invested when stocks are going up. It's much harder when you're retired, no paycheck is coming in, the market is down 30%, and you're withdrawing money every month.
Knowing that several years of anticipated distributions aren't dependent on selling stocks can change how that experience feels. You don't have to convince yourself that the market will recover by next Tuesday. You have time.
And time is one of the most valuable things you can give a long-term investment portfolio.
So How Much Cash Should You Keep in Retirement?
I wouldn't start with a percentage of your portfolio, and I wouldn't start by putting five years of expenses into cash. Start with your spending.
Subtract Social Security, pensions and other reliable income. Determine how much your investments actually need to provide each year. Then decide how much of those anticipated withdrawals you want positioned outside of equities.
For many retirees, I think roughly five years is a reasonable starting point. I generally prefer short-term fixed income for that portion of the portfolio rather than simply holding all of it in cash. Some retirees will need more. Some will need less.
The goal isn't to predict the next bear market or squeeze the highest possible return out of every dollar. It's to give the money you need soon a different job from the money you won't need for years.
