Money you will need in the next 5 years should not be in the stock market.
I have heard this advice for years, but never really paid much attention to it as far as my retirement.
After all, I wasn’t going to be retiring in the next 5 years. I was young, not even 30 (or 40, or 50). I had plenty of time to ride out the stock markets ups and downs.
Now, however, I am thinking about retiring. I might want to keep working for more than 5 years, but I might want to stop even sooner than that. It is time for me to start preparing for retirement and the sequence of return risk.
That means reducing how much risk I am taking with my investments, and probably building up my cash position.
My investments are not allocated properly for a retirement in the near future; they are far too stock heavy. This has been great for seeing huge returns in the past 10 years, but puts me at risk of seeing my nest egg shrinking tremendously right before or right after my last day of work.
So, I have been struggling to find the right path for me. I think the biggest issue has been wrestling with two opposing “truths.”
Cash is Trash
Often stated by the young and enthusiastic investor.
It is true, that without investing–without taking on the risk of losing money, in exchange for the chance (much better if your risks are diversified) of seeing your capital grow many fold–your nest egg will most likely not meet your needs.
Even with inflation at a temperate 2%, after 36 years (coincidentally, the duration of a decent career in Internal Medicine), your money at retirement will buy you half of what you could have had coming out of residency.
If inflation settles into the 6% range, you can see your buying power halved in only 12 years. Which means that by the time you retire, a nest egg will get you only 1/8th of what you could have had at the start of your career.
So… investing well is a must, if you hope to live well in retirement.
On the other hand, it is also true that a well-diversified portfolio tends to do well over time. It is not a guarantee that you will have healthy gains, ready for harvesting, at the perfect time for your exit from the world of work. This is where that other aphorism comes into play…
Cash is King
In 2020, when income slowed down, a lot of workers rediscovered this truth.
For many, the reliable paycheck dwindled or disappeared. At the same time, the market dropped significantly, and it wasn’t yet clear that an investment portfolio would recover quickly. Landlords had to deal with a rent moratorium.
I know I felt a lot better about my financial situation with a healthy balance in my savings account. I was worried about catching COVID, but not about paying my utilities. I think many other people (re) learned the importance of having some cash at the ready.
When I retire, my paycheck will, perforce, go away.
If my investments are doing well, I plan to take advantage of the favorable taxation of capital gains in the lower tax brackets to realize profits. Which I can then live on.
However, if shortly after I retire, the market takes a dive… my plan might not work out so well. That darned sequence of returns issue.
If this happens soon enough after I retire, I am sure I can go back to my practice and ask for work (how delightful, she said drily). Or explore locum tenens opportunity, or take a non-clinical job.
But, truly, when I decide that I want to retire, I want to retire. To live a life of leisure, or at least a life without an alarm clock or a deadline.
To do that with equanimity, without regard for the gyrations of the market, I really should have several years of spending in cash (or cash equivalents).
If I shouldn’t have money I need in the next 5 years in the market, that will mean that of my 25-30x yearly spending I have saved up, 5x should be in cash.
How much is that in dollars?
I am still not sharing my monthly spending (or assets) on this public blog. It almost doesn’t matter, as I have to guesstimate what my yearly spending might be in retirement, once my health insurance is not longer heavily subsidized. Not to mention other adjustments to my spending.
For now, those years before both Mr. PiN and I are covered by Medicare, I am projecting that we will spend much more than we do now.
I estimate that I can save somewhere between 4 to 6 months’ worth of (projected) spending each year from my current salary, while still contributing to my retirement account at work.
Which, if I were starting from scratch, means that it would take 10 to 15 years to save up 5 years’ worth of spending. At that point, both Mr. PiN and I would be on Medicare, and we would have more cash than we need.
However, I would definitely like to retire in less than 10 years.
Luckily, I do have some money put aside already: my current emergency fund, my sinking fund for house repairs, my secret savings account (earmarked for a new car when we need one, and possibly other projects). Plus uninvested cash (dividend payments) in my brokerage accounts.
Add them up, and I already have 1 and 1/2 years’ spending saved.
Now, some of that money is intended for other issues. By also planning to use it to fund early retirement (if the market is doing poorly), I am effectively planning to give up some of our fun plans if an emergency comes up. That is, if we need a new roof, or a new car, we may need to cut a lot of our elective spending that year (and maybe the next).
However, I am now looking at 7 to 10 years until I have amassed sufficient cash to retire.
If I receive (and save) any bonuses in the next few years, I suspect I can accelerate that timeline a bit further. By the very nature of my bonus, I have no idea how much any might be; but I do recall, from my efforts to pay off my mortgage, when I have a goal for this sort of money, it does add up faster than I think it will.
Set a goal, make a plan
I have to admit, I am not super excited with numbers that tell me to wait 7 to 10 years to retire.
But really, that’s just how long it might take me to save all the cash I think I need.
Maybe I don’t need as much to retire as I think. Maybe I feel more comfortable with only 3 times my yearly spending in cash, if I end up retiring into a bull market. Maybe I sell my house for a huge profit and buy a cheaper place for retirement (not in the current plans), using the difference to live on for a few years.
In the meantime, I have a plan: save cash.
I am going to find it challenging to change a habit of several decades–when money was earmarked for investing, or paying off debt. But having a goal is helpful to keep me focused.
In the meantime, I may have to start thinking about ways to maximize my cash. I suspect CDs may return to my vocabulary for the first time in years.
How much of your portfolio do you allocate to cash? Any words of wisdom as I start preparing financially for retirement in the next few years?
I think I have a little more than 2 years cash saved up, most stashed in CDs but actually the CDs definitely are losing money after inflation (let alone taxes) and some is in a checking account earning less than .5% interest. Maybe .1% interest? I’ve finally had enough and am transferring some of that cash to my brokerage account.
But I don’t have a great sense of my spending per se. It’s a very rough estimate based on how much I earn and how much I sock away. So for example, no idea what taxes might actually look like in retirement let alone health insurance.
I have about 70% in stock overall not counting the house. But my current goal is to have at least 10 years worth spending (roughly) in my brokerage account before retirement and am saving heavily there (80% stock) so I expect my equity allocation to continue to creep up. Especially with the market now, I am a few years away from that goal. Note, I do not count my bond allocation as “cash.” That’s more… ballast.
You didn’t mention it but what is your actual stock allocation? I suspect I have a lower stock allocation than you do.
Thank you for commenting, C. Also for inspiring me to check my brokerage account–after months of dropping, it is finally up (since the last time I checked). My retirement accounts are about 60% stocks, but my after tax brokerage account is almost all stocks (like 96%). It might be time to do a real check in, as I have been doing these last few Augusts.
I think that getting a good grasp of spending is really quite important. I have been tracking this for a long time. Even though I have to guess at my tax burden and my health care costs for the future, it is SO helpful to have a good idea of my annual spending over time. If nothing else, it lets me know how much I can afford to cut my hours, if I choose. I do recommend you try the exercise; with computers these days, it’s pretty easy to go through your bank accounts and credit card spending (cash is still hard to track, unless you keep a real time spending diary).