An Emergency Fund for Retirement

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Many individuals have heard about having an emergency fund while working and saving for retirement. Generally, the rule of thumb has been to keep 3 to 6 months of non-discretionary living expenses on hand in case one loses their job, becomes disabled, or an unforeseen emergency occurs. But what about those individuals who are nearing or already retired? What should their emergency fund look like? Do they even need one?

One of the bigger risks that pre-retirees and retirees face in retirement is sequence risk. Sequence risk is generally defined as the risk of even lower portfolio returns due to making withdrawals from a retirement account when the market has experienced a downturn.

In other words, a retiree experiences sequence risk when their retirement account drops in value due to market volatility, and they make a withdrawal (or withdrawals) after the account has dropped in value. Another way to put it would be similar to an individual saving for retirement in their 30s, yet selling at the market bottom and “locking in” their losses.

Understandably, this can be disastrous for any retiree who has a goal of their money outlasting them in retirement. There are a few things pre-retirees and retirees may consider to help with reducing sequence risk.

1. Consider having 1-2 years of living expenses in a savings account. This can help reduce the strain on the retirement account when markets are down by living off of the money in the “emergency fund” for retirement. Additionally, an individual may consider funding the emergency savings with money from the retirement account when markets are up in any given year. That is, sell from the assets classes that are up to replenish the cash account.

2. Consider longevity insurance (an annuity). By purchasing longevity insurance an individual can transfer some of the sequence risk to the insurance company providing the annuity. In the event that their non-annuitized portfolio drops in value due to market volatility, the individual can take some comfort in knowing they will not have to withdraw as much from their assets since they will be receiving a guaranteed income stream from the annuity.

3. Consider reducing spending temporarily. If possible, the individual can delay consumption until their portfolio improves. Granted, not everyone can afford to reduce spending (such as for health care, housing, etc.). But some individuals may find it to their advantage to put the vacation off a year, not dine out as much, or delaying discretionary purchases until their financial picture improves.

4. Optimize your Social Security. There are many advantages and nuances an individual or couple can consider when applying for and taking Social Security benefits. By taking advantage of the options available, individuals may be able to maximize their income from Social Security (essentially an annuity) and help provide more guaranteed income during volatile market times.