When you think of financial stability and freedom, what comes to mind? For many, it may be a home that’s paid off in full, zero credit card debt, or a six-figure portfolio. But what people tend to forget is just how fragile financial freedom can be, especially when there isn’t a savings net in place.
Your debt might be under control and your paycheck impressive, but one big emergency (say an accident or property damage) could change everything—especially if you don’t have easily accessible savings to cushion the blow. Preparing for a financial emergency is an often underrated component of a well-rounded financial plan. It becomes even more important as you transition to retirement and your portfolio serves as your primary source of income.
In a recent study by the Center for Retirement Research at Boston College, researchers found that the average retiree household spends around 10% of annual income on unexpected expenses.1 Without a plan in place, those unexpected costs have the potential to limit your spending power in retirement—or worse, diminish your portfolio’s longevity.
Let’s take a closer look at why emergency costs can be a higher financial risk for retirees and how to prepare your portfolio for unexpected expenses.
To be clear, preparing your finances for an emergency is important at any age and life stage. But once you reach retirement, your ability to recover from a large, unexpected expense lessens.
Earlier in life, you’re living on a paycheck and (ideally) contributing to a portfolio you don’t plan on touching for years—even decades. As the markets move up and down, your portfolio’s value fluctuates. But with time to ride out volatility, your portfolio generally has the opportunity to recover. In other words, you have one of the most powerful investment tools on your side: time.
In retirement, you’re not living on a paycheck—at least not in the traditional sense. Your “paycheck” stems from a mixture of income sources, including your 401(k), other investment accounts, Social Security benefits, and more.
Because you likely want your nest egg to last beyond your lifetime, your priorities usually shift in retirement from growing aggressively to preserving and protecting wealth. For that reason, a sudden, unexpected drawdown from your portfolio can have a lasting impact that’s hard (if not impossible) to fully recover from.
The need to preserve your assets in retirement is why financial professionals place so much emphasis on withdrawal strategies—in other words, how much you can safely draw from your accounts every year in retirement. General guidelines, like the 4% rule, exist as well to help retirees understand the importance of thoughtful spending.
Withdrawing beyond what’s deemed “safe” for your specific circumstances increases your longevity risk (the risk of running out of money in retirement). Yet, unexpected expenses happen—making it all the more important to prepare ahead and protect your portfolio for the long-term.
You’ve been filing tax returns for most of your life. But taxes in retirement tend to increase in complexity—making them a whole different ball game than what you’re likely used to.
Different sources of income face different tax consequences, whether they’re tax-free, taxable, or subject to a more favorable capital gains tax. Keeping your annual and lifelong tax liability in check typically requires a strategic withdrawal strategy with careful, multiyear tax planning and considerations.
Facing an unexpected expense may require urgent action, giving you less opportunity and time to make strategic tax-focused withdrawal decisions. You may be forced instead to make quick withdrawals that either increase your immediate tax liability or otherwise impact your future tax strategy.
There’s a phenomenon known as “sequence of returns” risk that can affect people retiring during a volatile market environment.
Essentially, large withdrawals early in retirement, particularly during a market downturn, can lock losses into place and reduce your portfolio’s ability to recover in the future. Even one-time withdrawals, if they’re large enough, can impact the value of your portfolio for life.
According to the Center for Retirement Research study, the average annual unexpected costs run a household around $6,000, though that number increases to nearly $11,000 for households with higher income.1
With emergency costs taking up around 10% of a retiree’s annual household expenses, this can equate to around two and a half years’ worth of retirement income across a 25-year retirement. Considering how hard you work to save for retirement, that’s certainly no small impact.1
Currently, around 58% of all surveyed households can cover their annual unexpected costs using cash, without tapping into their retirement savings.1
As you continue preparing for retirement, think about how you’ll protect the assets you worked hard to build.
First and foremost, acknowledge the need to plan for the unpredictable. If surveyed households annually spend an average of $6,000-$10,000 on unexpected expenses, consider this a starting point for savings. Or, reflect on your own spending over the past several years. What popped up recently that you weren’t planning to spend on? How much did it cost?
This could include:
While you can’t predict everything that’ll happen in the coming years (particularly once you transition to retirement), you can still try to protect your assets against what you can’t see coming.
Work slowly to build an emergency fund that could realistically cover the unexpected expenses you’re most likely to encounter. It’s better to add a few dollars to a separate savings account consistently than wait until you feel like you can make a significant contribution.
Your emergency fund should be in an easily accessible account, as liquidity is the priority here. Consider a high-yield savings account or money market account to keep your cash closeby, while still earning a little interest to help combat inflation.
An emergency fund can also be used to support your early retirement needs during a period of market volatility. If you’re facing sequence of returns risk during a market downturn, you may find it necessary to pull from cash reserves. Doing so would allow your money more time to recover before withdrawals begin.
Insurance policies are designed to protect against the unexpected. Everyone’s insurance needs will look a little different depending on their family status, life stage, other available assets, medical history, and other factors. Even as you age or your net worth grows, you may find the policies that used to support your family no longer offer enough coverage—or you’ve outgrown the need for certain policies altogether.
Ahead of retirement, consider what policies could offer critical protection and preserve more of your retirement income. These might include:
Keep in mind that policy premiums impact your spending and other financial goals. You’ll need to strike the right balance between protecting your assets and not overpaying on policies that don’t fit your needs.
As much planning as you can do to build your dream retirement, protecting it against unexpected expenses is critical. From an early market downturn to high medical costs later in life, you just don’t know what curveballs life’s throwing your way.
An emergency fund, as well as putting the right policies in place, can help you quickly address unexpected expenses without jeopardizing your other retirement resources. You may find it helpful to speak with an advisor about your specific needs and circumstances as you approach retirement.