How Much Emergency Money Should You Keep in Retirement?

According to financial experts, retirees should try to build an emergency fund with enough money for one to three years of necessary expenses.

That’s much higher than the three to six months of pay that workers typically have to set aside for emergencies, but it’s easier to recover from financial setbacks if you can still earn a paycheck.

For retirees, the decision depends on what is important to them and how much they are willing to spend on it, says Sarah Coles, head of personal finance at Hargreaves Lansdown.

Her company’s research, based on official statistics, found that people on the bottom fifth of incomes spend £748 a month on basic household costs, while those on the average income spend £1,685.

Hargreaves estimates that on average, people over 60 should have between £16,680 and £50,040 in an emergency fund.

“Where you are on this spectrum depends on your circumstances,” says Coles.

‘If you receive a generous guaranteed income from a final salary pension, you may have some room to save during your retirement and cover emergencies with your monthly payments.

‘If you have a lower income, you may need more.’

She adds: ‘If you are withdrawing money via an income drawdown and only want to withdraw the income from your investments, you will probably want to have enough money in your emergency fund. That way, you can top up the money you withdraw in times when your investments are not producing as much as you need.’

This is because of a nasty trap known as ‘pound cost ravaging’. This trap can cause serious damage to pension investments, especially in the early years of retirement if a financial crash occurs.

This means that if the markets fall, you will be hit with a triple whammy: a fall in the fund’s capital value, further depletion of the income you take and a fall in future income.

People who continue to generate income during those years will crystallize their losses and build up problems in the future.

> Beware of market shocks in early retirement: how to avoid ‘pound cost destruction’

Nick Nesbitt, partner and financial planning expert at Forvis Mazars, also advises seniors to set aside two to three years’ worth of expenses for their retirement.

According to him, this is because people are becoming increasingly dependent on invested assets to fund their retirement. You should try to avoid having to sell these assets to meet your daily needs during a recession.

“The aim is not to be dependent on invested assets if they decline in value, thus extending the life of the fund,” he says.

On the target of a maximum of three years of cash, Nesbitt adds: ‘That seems quite high, but if you look back historically, you can expect declines to continue for a few years.

‘If you only have money in six months, you will soon have to rely on invested funds.’

He says some of his clients keep their expenses in cash for five years, but that’s a bit more conservative.

How does a tax-free lump sum payment work?

According to Sarah Coles from Hargreaves, your emergency fund is likely to consist of pre-retirement savings and some of your tax-free pension.

But she warns that withdrawing tax-free money should not be done rashly.

“You will lose the ability to grow with your investments and in many cases you will lose the benefits of a tax-efficient environment,” she says.

Below we explain how taking a tax-free lump sum works in practice and what the pitfalls are.

People approaching retirement age often have a combination of defined contribution pensions that are invested, and defined benefit pensions that provide a guaranteed income until they die.

Defined contribution pensions: This involves investing amounts from both employers and employees so that there is a sum of money left over upon retirement.

People over 55 can withdraw 25 percent of their pension pot tax-free, or choose to withdraw it gradually in parts. The minimum age for private pensions will increase to 57 in April 2028.

If you don’t withdraw the entire amount at once, you will have more tax-free money left over in the long run as your pot grows in the future.

Fixed pensions based on salary: Final salary or average benefit pensions provide a guaranteed income after retirement for the rest of your life.

Your options for a lump sum payment of 25 percent will vary depending on the generosity of the terms of your scheme, so you will need to check the specific details.

You can choose to transfer a final salary pension to an invested withdrawal plan. However, financial experts say this is rarely a good idea and the government has taken steps to prevent people from unknowingly giving up valuable pension rights.

If your final salary pension is more than £30,000, you are required to seek paid financial advice before giving it up.

Where to Keep Your Emergency Fund

A significant portion of the money should be held in a savings account or cash ISA so you can access it in an emergency, says Coles.

For money that you don’t need for at least three months, you might consider a fixed-rate account.

‘These guarantee an interest rate for the entire period of the fixed interest rate period, regardless of what the Bank of England does with the interest rates.

‘It often makes sense to fix parts of your pension savings for different periods. This way you benefit optimally from guarantees and still keep money available.’

She adds: ‘It’s worth considering an online savings platform that allows you to hold several competing accounts and move money around quickly and easily.’

According to Coles, this also allows you to spread your money across accounts at different banks, keeping it under the £85,000 deposit limit. This limit is automatically protected by the Financial Services Compensation Scheme, and you can still manage it all in one place.

If you put your pension into an investment plan to fund your retirement, you can also keep some of it in cash within the plan.

Nick Nesbitt of Forvis Mazars says this could be an advantage for high-tax taxpayers, who can avoid income tax on cash withdrawals that then go into an emergency fund. It is also an advantage for those who need to protect their estate from inheritance tax.

On the other hand, you can usually get better interest rates outside of a pension plan, he says. And he points out that pension and inheritance tax rules can change.