How much to hold in cash

Cash holdings in retirement serve several distinct purposes, and confusing them leads to holding either too much or too little.

The three purposes

Near-term spending. Money needed within a year should not be exposed to market risk. This is not an investment decision.

Sequence protection. Additional cash allowing withdrawals during a market decline without selling equities.

Genuine emergencies. A roof, a vehicle, a medical event, helping a family member.

Each implies a different amount, and adding them produces the total.

The cost of holding it

Worth being explicit about, because cash is treated as free.

Cash generally returns less than other assets over long periods and, after inflation, has frequently produced a negative real return.

Holding three years of spending in cash within a portfolio meaningfully reduces expected returns.

That cost varies with prevailing rates. When short-term rates are reasonable, cash is much less expensive to hold than when rates are near zero.

Which means the right amount is not fixed and should be revisited as conditions change.

Reasonable amounts

For near-term spending: enough to cover the coming year's withdrawals, replenished periodically.

For sequence protection: commonly one to three additional years, with the amount depending on how much guaranteed income covers essential spending.

Someone whose essential costs are entirely covered by Social Security and a pension needs much less sequence protection than someone whose portfolio funds everything.

For emergencies: a defined amount rather than a multiple of spending, based on plausible large costs — a deductible, a major home repair, a vehicle.

Total holdings of one to three years of spending cover most situations. More than that is generally an unexamined preference rather than a plan.

Where to hold it

The instrument matters more than it used to.

Bank savings accounts vary enormously in the rate paid, and the difference between a default account at a large bank and a competitive online account is substantial on a meaningful balance.

Money market funds generally track short-term rates closely.

Short-term government securities can be purchased directly or through funds, and ladders of maturities provide predictable availability.

Certificates of deposit offer fixed rates in exchange for locking up funds, with penalties for early access.

Deposit insurance limits are worth knowing for anyone holding large balances at a single institution.

The behavioural argument

The strongest case for holding more rather than less.

The most damaging thing a retiree can do is sell equities during a decline. Anything that makes that less likely has a value not captured in expected return calculations.

Someone who sleeps better and behaves better with three years of cash is probably better off with three years of cash, even though a spreadsheet would recommend less.

This is a legitimate consideration rather than a concession, and it should be stated as such rather than disguised as optimisation.

The over-holding problem

The opposite error, which is common among people who retired after a period of market stress.

Very large cash holdings guarantee a loss of purchasing power over a long retirement, and that loss is invisible year to year.

Someone holding ten years of spending in cash has taken on substantial inflation risk in order to avoid market risk, and over thirty years the first is generally the larger threat.

The check worth running: what proportion of the total portfolio is in cash, and would you have chosen that as an allocation if asked directly?

Refilling

The practical mechanism that makes this work.

Define, in advance, how the cash reserve is replenished — annually from whichever asset class has performed best, or only after positive years, or on a fixed schedule.

Without a rule, the reserve is either never refilled or is refilled by selling at the wrong time, which defeats its purpose entirely.

The couple consideration

One practical addition.

Cash should be accessible to both people in a household, not held solely in one person's name.

Accounts held individually can be temporarily inaccessible after a death, at exactly the point when immediate expenses arise.

A jointly held reserve covering several months of costs avoids a problem that is entirely predictable and routinely encountered.

General information only, not financial advice. Interest rates and deposit protection limits vary — consult a qualified adviser about your own situation.