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Retirement Finances: Financial experts suggest keeping one to three years of essential expenses in cash
Retirees should try to maintain an emergency fund equal to one to three years of essential expenses, financial experts say.
That’s far more than the three to six months’ salary that workers are generally advised to set aside for a rainy day, but it’s easier to recover from financial shocks when you can still earn a wage.
For retirees, the decision depends on what is considered essential and how much is spent on those things, says Hargreaves Lansdown personal finance director Sarah Coles.
His firm’s research, based on official statistics, shows that those in the lowest income quintile spend £748 a month on basic household expenses, while those in the middle bracket spend £1,685.
Hargreaves estimates that, on average, over-60s should aim to have between £16,680 and £50,040 in an emergency fund.
“Where you fall on this spectrum depends on your circumstances,” Coles says.
‘If you have a generous guaranteed income from a final salary pension, you may have room to save in retirement and cover some emergencies with your monthly payments.
“If you have a lower income, you may need more.”
She adds: ‘If, in the meantime, you are taking money out through income withdrawals and plan to only withdraw the income from your investments, you may want to have enough cash in your emergency fund, so you can supplement what you are withdrawing at times when investments are not earning as much as you need.’
This is linked to a nasty trap known as “pound-cost devastation”, which can cause serious damage to pension investments, especially in the early years of retirement, if a financial crisis hits.
This means that when markets fall, you suffer the triple whammy of a fall in the fund’s principal value, further depletion due to the income you are withdrawing, and a fall in future income.
People who persist in earning income during those years will crystallize their losses and accumulate problems for the future.
> Beware of market shocks in early retirement: how to avoid ‘pound cost erosion’
Nick Nesbitt, partner and financial planning expert at Forvis Mazars, also recommends that older people keep two to three years’ worth of their expenses in reserve during retirement.
He says this is because people are becoming increasingly reliant on invested assets to fund their retirement and should try to avoid having to sell them to cover daily needs during market downturns.
“The goal is to avoid having to rely on invested assets when their value declines, thereby increasing the longevity of the fund,” he says.
On the target of up to three years of cash, Nesbitt adds: “It seems quite high, but if we look historically we can expect declines to last a couple of years.
“If you only have six months’ worth of cash, you will quickly need to tap into invested assets.”
He says some of his clients have five years’ worth of expenses in cash, but they are the most cautious.
How do tax-free lump sums work?
Your emergency cash fund is likely to be made up of pre-retirement savings and part of your tax-free pension lump sum, says Sarah Coles of Hargreaves.
But he warns that accessing tax-free money should not be done without serious consideration.
“You will lose the ability to grow your investments and, in many cases, you will be giving up the benefits of a tax-efficient environment,” he says.
Below we look at how a tax-free lump sum payment works in practice and some of the drawbacks.
People approaching retirement age often have a combination of defined contribution pensions, which are invested, and defined benefit pensions, which provide a guaranteed income until death.
Defined contribution pensions: These take sums from both employers and employees and invest them to provide a pot of money for retirement.
Those aged 55 and over can withdraw 25 per cent of their pension pot tax-free in advance, or choose to withdraw it gradually in instalments. The minimum age for a private pension will rise to 57 in April 2028.
By not withdrawing the entire sum at once, if your money grows in the future, you will have more tax-free cash available to withdraw over the long term.
Salary pensions with defined benefits: Defined benefit pensions with final salary or career average provide a guaranteed income after retirement for the rest of your life.
Your options for getting a one-time 25 percent payment vary depending on the generosity of your plan’s terms and conditions, so you’ll need to check the specific details.
You have the option of transferring a final salary pension into a retirement plan that is invested, although financial experts say this is rarely a good idea and the Government has put safeguards in place to ensure people do not inadvertently give up valuable pension benefits.
If your final salary pension is worth more than £30,000, it is mandatory to seek paid financial advice before giving it up.
Where to keep your emergency cash fund
A significant portion of the money should be in easily accessible savings accounts and cash ISAs so that it can be accessed in an emergency, says Coles.
For money you won’t need for at least three months, you may want to consider fixed-rate accounts.
‘This will guarantee one rate throughout the fixing period, regardless of what the Bank of England does with interest rates.
‘It often makes sense to set aside portions of retirement savings over different periods, to make the most of the guarantees while keeping cash accessible.’
She adds: “It’s worth considering an online savings platform, which allows you to have a variety of competitive accounts and move money around quickly and easily.”
Coles says this also allows you to spread your money across accounts in different banks, to keep it under the £85,000 deposit limit that is automatically protected by the Financial Services Compensation Scheme, and still manage it in one place.
If you put your pension into a retirement investment plan to fund your retirement, you may also want to keep some of it in cash within the plan.
Nick Nesbitt of Forvis Mazars says this can be an advantage for higher-rate taxpayers, who can avoid an income tax bill on cash withdrawals that will simply sit in an emergency fund, and for people who need to protect their estate from inheritance tax.
On the downside, better interest rates can usually be obtained outside a pension plan, he says, noting that pension and inheritance tax rules can change.
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