Cash Buffer Will Save You In Retirement

cash buffer 2

THE golden rule of retirement is: Don’t run out of money. In fact, it’s pretty much the only rule.

You don’t want to be living off bread and water as you dodder along towards death.

That’s why having a cash buffer in place before you quit your job is so important.

It forms a crucial part of my early retirement planning and I wouldn’t feel comfortable leaving the world of work without one.

Now, before we go any further, let me be clear. When I say “cash buffer” I’m not talking about your retirement investments (which should total at least 25x your annual spending so you withdraw and live off 4% each year).

No, this is something different.

Think of it like a super emergency fund.

What Happens When Your Investments Hit The Buffers

The idea of a cash buffer is to protect your main retirement account during a stockmarket crash.

You don’t want to be taking money out and selling investments to pay bills during those bad times. If you do that it will eat away at your overall fund faster than this guy demolishing a slice of watermelon.

Quick Example

Year One

Say you need 20,000 a year so you have a pot worth 500,000 (4% of 500,000 = 20,000).

Then the market drops 20%.

Suddenly your fund is worth 400,000. You still need that 20,000 to live, leaving you with a pot of 380,000.

(Withdrawal rate 5% – outside of acceptable limits)

Year Two

The market drops by another 20%. Your pot is now worth 304,000. You take another 20,000 because bills have to be paid.

Now you only have 284,000.

(Withdrawal rate 6.5% – totally outside of acceptable limits)

Year Three

The market drops 10%.

Your pot is now worth 255,600. You take another 20,000 because you like having shelter and food.

Now you have 235,600.

(Withdrawal rate 7.8% – almost double acceptable limits)

Even if the market then stabilizes and from then on records 4% gains forever, you’ll STILL run out of money after just 15 YEARS.

Scary isn’t it?

What’s the solution?

Your cash buffer allows you to leave you retirement account untouched when everyone else is panicking about stockmarket drops.

Instead, you sit back and chill. You live off your cash buffer for a while and won’t have to sell low, when things are in the toilet.

This means your investments last longer and it also increases returns over the long term. All good news, I think you’ll agree.

cash buffer

So How Big A Cash Buffer Do I Need?

That’s the big question, and the answer will be different for everyone. It depends on how long you think a future stockmarket crash will last.

My crystal ball is still on the blink, but personally I’m going to save three years of annual expenses and put it into the highest interest-bearing bank account I can find. That’s my safety net.

I’m betting that after any crash, things will look a heck of a lot better within three years. That should help to smooth out the inevitable volatility of being invested in the stockmarket.

The cash buffer has to be in place before I retire. I don’t like risk, and won’t take any chances when it comes to my future well-being.

If you’re especially cautious, you could increase your cash buffer after retirement. Say things go well in the early years and your investments return more than the 4% your need each year to live off.

You could take the excess money and add it to the buffer.

Of course, this will probably reduce returns over the long term, but it will increase your peace of mind. You need to decide what is best for you.

But no matter what you do, don’t forget that cash buffer before you tell your boss where he can stick his job!

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Have you planned a cash buffer for retirement? How much do you reckon you’ll need to be safe? I’d love to hear from you in the comments below. If you found this article helpful, please share it using the Twitter icon. Thanks for reading.

Simon Saves

I'm a national newspaper journalist for hire who has a passion for personal finance. Currently saving and investing towards my first million. All comments welcome.Follow me on Twitter: @MyRichFuturecom

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2 Responses

  1. Mike says:

    This is a fantastic article. I’ve done some further analysis which suggests that having a 3 year cash buffer reduces the chances of running out of money after 30 years from roughly 10% to 1%. You can read more at https://sothatshowyoudoit.wordpress.com/2016/04/02/the-effect-of-a-cash-buffer-on-returns/

  1. April 2, 2016

    […] 2, 2016 ~ Mike Simon Saves over at MyRichFuture.com wrote a fantastic article entitled “Cash Buffer Will Save You In Retirement“. He argues that holding cash (he plans to hold three years worth of expenditure) in addition […]

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