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When estimating how much income you’ll need to live on in retirement, don’t forget to consider how you’ll cover unexpected expenses.
More than 8 in 10 (83%) retired households will face unplanned expenses in any given year, according to a new study from the Boston College Retirement Research Center. Households that experience unexpected expenses spend an average of $6,000 a year in retirement. Measured another way, the typical household spends the equivalent of 10% of their annual income.
But research shows that many households don’t have emergency savings. About 58% have enough cash to cover unplanned expenses in a single year, but about 16% will need to tap into a 401(k) or other retirement account, and about 27% will still come up short even after using all their cash and retirement assets.
“About 40% of[retired]households do not have enough cash to cover even one year’s worth of[unplanned expenses]let alone their entire retirement,” the study said.
The study uses data from 3,427 retired households who participated in the University of Michigan’s 2000-2020 Health and Retirement Study and Spending and Activity Mail Survey.
It is important to have some cash saved
Experts generally recommend that non-retirees set aside three to six months’ worth of living expenses in emergency savings in case of job loss or other financial shocks, but that amount may be different for retirees. Retirees must think about how to grow their savings over a retirement that can last for decades.
Considering unexpected expenses is an important part of evaluating retirement preparedness, as many retirees struggle to keep up with rising prices.
“This helps plan liquidity for income needs,” said Anki Chen, co-author of the report and associate director of savings and household finance at the Center for Retirement Research.
While some households may have a hard time saving money, “even a small amount of savings can provide some cushion when something like this happens,” Chen said.
The study divides expenses into three categories:
“Rain day” expenses, such as car maintenance costs of $500 or more and home maintenance costs of $1,000 or more; Family-related expenses, such as the death of a spouse or financial support for a family member; Medical expenses, such as dental or prescription costs, of more than $500.
The Center for Retirement Research estimates that 60% of all retiree households will face a surprise shock. 29% believe family-related expenses will occur unexpectedly. and 58% will face unexpected medical costs.
Research shows that high-income retirees are more likely than lower-income retirees to experience these unexpected expenses. For example, about 45% of households with incomes less than $50,000 face a rainy day or medical shock during the year, compared with 80% of households with incomes of $100,000 or more.
“These findings highlight the fact that households have some control over the timing and amount of their spending,” the report said.
Think in terms of “access to cash for surprises”
So, how much should I have secured? Depending on a retiree’s individual situation, a financial advisor may recommend anything from three to six months’ worth of expenses to several years’ worth of expenses, or variations in those parameters. A lot of it depends on your individual situation.
“What we always tell our clients is to think not in terms of months of expenses, but in terms of having cash for unexpected things like medical bills, home repairs, family needs, etc.,” says June Um, a tax advisor and certified financial planner at Secure Tax & Accounting in Beverly Hills, California.
“For many retirees, that ends up being a year’s worth of major expenses adjusted for guaranteed income like Social Security and pensions,” Um said.
The right amount depends on how flexible your health, housing, income stability and other assets are, Um said.
“Retirees with stable incomes and liquid portfolios may need less cash, while retirees with higher medical risks or less flexibility need more cash,” Umm said. “The goal is not to maximize cash; it’s to have enough cash on hand to avoid selling long-term investments at the wrong time.”
In other words, not setting aside enough cash could put you in the position of selling your investments when the market declines.
Avoid carrying too much cash
But holding too much cash comes with its own risks, says Peter Lazaroff, chief investment officer, chartered financial analyst and CFP at Plancorp in St. Louis.
“If a retiree has more than two years’ worth of expenses in cash, that’s too much,” Lazaroff says. “From a purely mathematical perspective, you’re giving up too much benefit.”
The biggest risk to cash, he says, is inflation. The annual inflation rate was 2.7% in December, according to the latest reading of the Consumer Price Index.
“The value of cash just goes down every year,” he says. “You’re putting your purchasing power at risk.”
He recommends stashing your cash in a high-yield savings account (which currently typically earns more than 3% interest, according to Bankrate) to minimize the impact of inflation.
