The crucial role of a larger emergency fund in retirement

If you're planning to retire soon, you're probably thinking about money a lot. However, you may be overlooking your emergency fund. An emergency fund is a simple thing that is really important: It is a savings account used only for unexpected needs. Financial experts often recommend that you save three to six months' worth of expenses in this fund.

While the concept of an emergency fund is not new, its importance has been underscored by recent global events. The COVID-19 pandemic, for instance, highlighted how quickly financial circumstances can change. Many retirees who thought they were financially secure found themselves facing unexpected challenges. This reinforces the need for a robust emergency fund, especially for those entering retirement.

However, one financial planner believes that this will alter in retirement. Maintain a greater emergency fund for retirement—you'll need around 12 months of spending. While you may manage with a smaller emergency fund while working, you'll need a larger one after retirement.

According to financial advisor Mamie Wheaton of LearnLux, having the extra income will provide additional protection. "I would generally recommend around 12 months of liquid expenses on hand for retirees or someone who is just about to go into retirement," she informed me.

Wheaton refers to liquid savings as money that is not invested in a retirement plan. Instead, emergency money should be kept in an easily accessible account, such as a high-yield savings account. It will continue to earn a tiny interest while waiting to be used.

It's worth noting that the concept of a high-yield savings account has evolved in recent years. With the rise of online banks and fintech companies, retirees now have more options than ever to maximize the return on their emergency funds. Some of these accounts offer interest rates significantly higher than traditional brick-and-mortar banks, allowing your emergency fund to work harder for you while still remaining easily accessible.

That is larger than a standard emergency reserve. She does, however, state that 12 months is not the most length of time you can maintain. "Everyone has a comfort level on the amount of cash they want to hold," she informed me. Having a few months extra may be a good idea for someone who needs extra security.

Your emergency fund can be utilized for a variety of purposes, including home repairs and unforeseen costs. However, after retirement, there are a few more instances in which your emergency fund can be used safely.

One situation is that it is not advantageous to withdraw funds from your retirement plans if the market falls and your portfolio is worth less. Wheaton suggests using your emergency cash rather than your retirement account.

"If you have a lot of your retirement investments in securities, that's where you would probably want a little bit more of a cash buffer so that you don't have to pull from those accounts in the event of a market downturn," she told me. "You can let it recover."

This strategy of using an emergency fund to avoid selling investments during market downturns is particularly crucial for retirees. It's a concept known as sequence of returns risk. Essentially, the order in which you experience investment returns can significantly impact your retirement savings. If you're forced to sell investments when markets are down, especially in the early years of retirement, it can have a lasting negative impact on your portfolio. A robust emergency fund acts as a buffer against this risk, allowing your investments time to recover.

In addition to having funds to cover your costs if the market falls, a greater emergency fund in retirement could assist you with medical emergencies and bills if necessary. Some bills may not be covered by Medicare or private insurance, leaving you — and your emergency fund — to pay for what you need.

"They should plan for higher health costs, such as mobility concerns. You don't give it much thought, but it's often overlooked. When a mobility issue arises, you will have to pay for it yourself," she explained. That's where your emergency money comes in.

Wheaton recommended that you increase your emergency reserve to protect your retirement savings. "In general, you should avoid withdrawing substantial quantities of money from retirement accounts at once. If you have an emergency or a medical expenditure that needs to be paid for, it's better to use your emergency money rather than your retirement account."

Another often overlooked aspect of retirement planning is the potential need for long-term care. While it's not pleasant to think about, the reality is that many retirees will require some form of long-term care in their later years. This can be incredibly expensive and is often not fully covered by Medicare. A robust emergency fund can provide a crucial financial cushion in these situations, potentially covering initial costs while you explore long-term care insurance options or make arrangements for ongoing care.

That way, your retirement savings will continue to grow and be there when you need them, while your emergency fund will help to cover the unexpected.