How Much Cash Should You Have in Your Retirement Portfolio?

This is a question that yields a lot of different answers. Cash (or cash equivalents like money market funds, savings accounts, short-term bond funds) currently pays next to nothing in interest. The best money market rates today are only around .5%*, thus they do not even keep up with inflation. You’re really losing money to inflation by holding it in cash.

That said, there are still reasons for you to hold cash. First, I want to distinguish between having cash outside of your retirement portfolio and cash designated for retirement. We should all have 2 to 6 months of expenses set aside in cash as an emergency/opportunity fund. If you have access to good credit, then 2 months may be OK. If you’re conservative or feel your normal income may be at risk or is inconsistent, then closer to 6 months is probably better. Also, if you’ll need funds for a large expense coming up such as a vacation or new car, that should be in cash as well. So, we all have a need for some extra cash savings with immediate access.

But what about cash in your retirement portfolio? That’s where the experts disagree. This is about asset allocation so there is no best answer. There is no one perfect allocation, rather a broad range of what is reasonable.

If you’re a young or middle-aged saver with over 20 years to go, your retirement portfolio may require no cash at all. If you’re looking to reduce the volatility of your portfolio, it will do so, but possibly at a cost of lost earnings over a longer time horizon. Some people like to hold cash for “buying opportunities”. But this is really market timing and most people cannot do this efficiently over time.   

Once you’re at the doorstep of retirement or already there, that’s when the discussion of cash in your portfolio becomes interesting and that’s where opinions diverge. I’ve seen recommendations anywhere from no cash necessary up to 3 years of income set aside in cash. I think it’s somewhere in between and here are some factors that may impact your cash needs.

If you are retired and have a large steady stream of guaranteed income from pensions and Social Security that more than covers your current income needs, you can stay more aggressively invested in your retirement portfolio as you can let those dollars ride the market up and downs. I do not see a need for a large cash position in this scenario. But if you are retired and you are spending down a lot of your retirement dollars as you wait for a pension or social security to kick in, you should probably keep 2 to 3 years’ worth of income in cash. You can’t afford a big market decline on dollars you’ll need to use.

But most people in retirement have a more balanced set of income sources like a 401(k) and Social Security that are working together. Social Security may not cover all your income needs so you need to draw down your other savings as well. I suggest that you look at your cash position like a larger emergency fund. In this scenario it may be wise to have 1 to 2 years of income in cash. In these cases, you would still use it for unexpected expenses that arise. But you could also use it for additional income if you want to stop taking income from your invested portfolio. An example would be if the market has a sharp decline, and you want to leave your portfolio alone until the portfolio value recovers. Your emergency fund is now big enough to help you with both unforeseen expenses plus unforeseen income needs.

There is probably a place for cash in your retirement portfolio. Just remember that letting a large amount sit in cash over a long time will probably cost you some future retirement income.

Enjoy the Journey!

*This post assumes a normal interest rate environment and not a high interest rate environment like the late seventies and early eighties.