Every book and article on basic personal finance cautions baby boomers and other working adults to have an emergency fund equal to three months to a year of basic living expenses.
The retirement emergency fund serves a completely different purpose. That purpose is to protect retirees from permanent damage to their retirement income stream caused by a severe downturn in the stock market. In fact, you could give the retirement emergency fund a different name: the “wait out the market storm” fund.
I believe that most baby boomers are hoping to have an income in retirement that is a combination of Social Security benefits and income from the investments in their retirement portfolio. Some will be fortunate enough to have a third income component in the form of a pension.
Boomers are also hoping that this combination of income sources will remain relatively stable over their lifetimes. For that to happen, yearly withdrawals from the retirement portfolio must be carefully planned. (I will be thinking and writing a lot more about withdrawal rates in the future.) A stable and sustained retirement income also requires careful selection and allocation of investments, including regular retirement portfolio analysis.
What can really disrupt all of this retirement income planning and analysis is a substantial and sustained drop in the market value of a retirement portfolio. The damage caused by such an event is particularly bad if it occurs early in retirement. To explain, let’s assume that you begin retirement with a retirement portfolio worth $400,000. Using the infamous 4% retirement withdrawal rate rule (which I don’t agree with but more about that in a future post), you plan on withdrawing $16,000 annually (adjusted for inflation) from your portfolio to supplement Social Security and/or pension income.
Now let’s assume a 2008 happens. The market falls dramatically and, maybe in the first year of retirement, the value of your retirement portfolio declines from $400,000 to $240,000. Now what? If the market stays down for a few years and you continue to withdraw at the 4% rate, you will very likely outlive your portfolio. (You can run the numbers through one of the portfolio analysis tools to see that for yourself.)
So if the markets crash the value of your portfolio, what are your options? One is to stop or reduce the level of your withdrawals, thereby lowering your standard of living. That’s no fun at all and in some cases is not even an option. The other option is to shift some or all of your retirement income withdrawals to your retirement emergency fund. This preserves what remains of your retirement portfolio and gives it a chance to rebound when the markets rebound. That is why baby boomers need to have that retirement emergency fund.
If we consider that a market downturn could last 3-5 years, you can see that a retirement emergency fund will need to be substantial in size. Fore example, if you are counting on $25k in annual income from your retirement investments and you want to protect against five years of sustained market downturn, you might want as much as $125k in your retirement emergency fund. Not everyone can afford to do that, but even a fund of $45k would allow you to reduce your annual withdrawal rate from your retirement portfolio by $15k during a three-year market downturn.
So what are our options for building a retirement emergency fund? We know that the number one criterion for establishing and maintaining the fund is stability. That means our fund options are limited to secure savings vehicles that are not going to deliver spectacular returns. Indeed, we would be fortunate if our emergency fund simply kept pace with inflation.
We do not want to use funds in a qualified retirement account (such as an IRA or 401(k) for our retirement emergency fund because at some point the required minimum distribution rules might force us to withdraw funds when we don’t want or need to. Moreover, we want to save those retirement account funds for long-term, tax deferred growth.
Mr. GoTo believes that leaves us with these options for a baby boomer building a retirement emergency fund: (1) FDIC insured savings account; (2) a CD ladder; (3) a stable asset value mutual fund; and (4) I-Bonds.
The FDIC insured savings account option has two weaknesses. First, you will be paying taxes on the interest every year. Second, money in a bank savings account is too easy to access and may tempt us to use it for something other than weathering a market storm.
The CD ladder option has the same taxation problem. A second issue is that maintaining a CD ladder requires ongoing maintenance, constantly monitoring rates and expiration dates so that the ladder is rebuilt. A positive is that, like the savings account option, the CD’s in the ladder are FDIC insured if you purchase them from an FDIC-regulated financial institution.
The stable asset value mutual fund can work although it is not insured, is subject to taxation, and may well deliver lower returns compared to the other options, particularly when considering mutual fund expenses. Also, stable asset value funds are hard to find in the open market, as they are primarily used inside a 401(k) plan or a variable annuity product.
That brings us to I Savings Bonds which Mr. GoTo believes represent one of the best options for building your retirement emergency fund. They are backed by the U.S. government, easy to purchase and maintain, provide inflation protection, and are tax-deferred. I have previously written about why I like I-Bonds in a retirement portfolio. Using them in an emergency fund is part of the reason.
There is no reason why you cannot use multiple options for your retirement emergency fund. For example, depending on how many years you have left before retirement, the annual limits on I-Bond purchases may restrict you somewhat. In that case, you can use both I-Bonds and an insured savings account.
If you are still ten or more years from retirement, you can actually start building your retirement emergency fund using more aggressive investments now, then move the accumulated value into a more conservative option as your retirement date approaches.
Finally, one option I have been thinking about as an alternative to a true retirement emergency fund is a single premium life annuity. With this strategy, instead of keeping emergency fund cash around, I would use that cash at retirement to purchase an annuity that, when combined with Social Security, will allow Mrs. GoTo and me to live without having to withdraw from our retirement portfolio in a down market. I am going to further consider this strategy and write more about it later when I talk about annuities in general.
What other strategies can you think of for building an emergency fund to be used in retirement?
Photo credit: Michelle Dennis