Managing your financial life is not just about money.

Sequence Risk & Emergency Reserves in Retirement

This is the eleventh article in a series.  In this piece I will answer questions 24 and 25 of 32 questions that you must answer before choosing to retire

  1. What do I do about “sequence risk”?

There are some things you can’t control in retirement, and “sequence risk” is one of the biggies!  Say that you assumed a 4% per year return from your retirement nest egg to make retirement work.  If you earn 8% per year for the first five years of retirement, you are a happy person and probably contemplating spending more in retirement.  If you average a -8% per year return for the first five years in retirement, you are in retirement hell. This is an example of sequence risk.  It is the order in which your yearly investment returns come to you.

Another example is that you can go broke averaging a good investment return. Ten years of 15% returns and ten years of -10% returns average a 5% per year return. If you experienced ten years in a row of those minus 10% per year returns just as you begin retirement and plan to take 5% per year from the portfolio, your retirement is toast!

What can you do about sequence risk?  Well, there are some advance analytical tools available that perform what is called a Monte Carlo Analysis.  These programs make some guesses about what sequence risk may do to your retirement plans.  They run hundreds, if not thousands of possible investment scenarios for your retirement. You end up with a success percentage number.  If there were 1,000 scenarios and the percentage was 90%, that means that in 900 scenarios you did not run out of money before you ran out of life. That also means there were 100 times you weren’t so lucky. Would you go ahead and retire with a 90% chance of success?   How about a 70%?  What’s your number? Remember Monte Carlo is not guaranteed and is just a guess. The guess is based upon some assumptions (guesses) that are made in the analysis. However, it is probably a better guess than yours. A comprehensive written financial plan for retirement should include a Monte Carlo analysis. If not, get a plan that does.  And ask a lot of questions about how it works and what it means.

  1. How much do I need in Emergency Reserves?

A general rule of thumb (that may not apply to you) is between 3 and 6 months of after-tax expenses should be sitting in a bank somewhere in the form of a money market fund or savings account for Emergencies. If your monthly expenses come to $4,000, then you need somewhere between $12,000 and $26,000.  A vacation is not an emergency, nor a large monthly charge card bill. Purchasing a car is not an emergency. If you use some of these funds, they need to be replaced.

In retirement I am not sure that you use that rule of thumb.  If you are a couple with two pension checks and two social security checks and life is good, you probably don’t need to carry large Emergency Reserves.  If you have a large sum of nest egg money, most of which you don’t need, then you probably don’t need to have a big Emergency Reserves Fund either.  If your retirement plan suggests that retirement will be pretty tight, you may want to carry a large Emergency Reserve Account, because stuff happens.

In the end, your Emergency Reserves number is a comfort number that makes you feel secure.  I would start with a larger Emergency Reserves pot than you think you need in retirement. You can always cut it back later, if you don’t think you need it.  It is much more difficult to start small and need to build a bigger one.  Please do not go into retirement without an Emergency Reserves Account that makes you comfortable!

In my next article in this series I will answer the following questions: 26. Do I want to leave anything for my kids?; 27. How should my nest egg be invested in retirement?; and 28. How do I take money from my nest egg in retirement?

If you have a question for me, I can be reached at mike@McNamaraFinancial.com. I promise that I will respond.

Michael J. McNamara Ph.D., CFP®

CERTIFIED FINANCIAL PLANNER™

*Any financial advice in this article is intended to be generic in nature. Readers should consult with their own financial advisors before implementing any advice or suggestions above.

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