Emergency fund & sequencing of risk

In a previous post, Emergency fund … Mojo .. FU Money, I explained the need for an emergency fund. To recap, my emergency fund is set up in an online high interest savings account (HISA). It is easily accessible should I need it, whenever I need it. I don’t have to jump through hoops to access it.

My goal now is to continue to build this emergency fund & contribute weekly until I retire – yes, you read it right – until I retire.

Conventional wisdom in personal finance worlds suggest I have three to six months of living expenses in the emergency fund. The advice for retirees range from having one to three years of living expenses saved to the very conservative three to five years! (My blood pressure rises just typing the last sentence)

Why? This is to protect against ‘sequencing of risk’. Let me explain – for most people, money set aside in retirement accounts is often invested in shares on the stock market. In order to live in retirement, shares are sold to generate an income.

So what happens if the stock market crashes right at the time you want to retire? Or just before your long awaited, longed-for retirement date? Your retirement nest egg is now significantly reduced AND you may have to sell your shares at a loss. Do you delay your retirement? Postpone that overseas trip?

In Australia, many retirees invest in dividend producing shares e.g. Telstra, Commonwealth Bank etc as another strategy. These are shares that traditionally in the past have paid a high dividend. In this way, even if the share market crashes, passive income in the form of dividends are still forthcoming. These companies may not pay out as well to shareholders in bad times (compared to the good times) but they will still pay something.

However, if you have cash readily available, you can use this cash to overcome any shortfalls in dividend income. It should see you through for the short term. You do not need to incur a loss by selling any shares at unfavourable prices. It will buy you some time to allow the stock market to recover. History has shown that the stock market will recover & share prices will rise again, but it may take some time as in years, not months.

As I am in my late forties, I need to prepare for traditional retirement, considering I may very well not achieve the RE (Retire Early) part of FIRE. It has taken me more than six months to save up to two months of living expenses. So it will take me ages to save three years worth of  living expenses. My strategy is to reduce my weekly contribution once I hit the six month figure and just keep going until I retire, whenever that may be.

I understand there is an opportunity cost here. This cash that is accumulating could very well be invested elsewhere with a higher rate of return. Currently my online high interest savings account (HISA) is paying 2.8% interest (if I meet the minimum requirements of depositing at least $200 per month with NO withdrawals). Interest rates have been low in Australia for a while. I will continue to monitor HISA’s interest rates as this cash reserve is building unobtrusively in the background. 

As I continue on the path of increasing my savings rate and reducing living expenses, the amount I need to save will decrease correspondingly. So this is really a work in progress!

Right now, my plan is to always have six months of living expenses in a HISA. Once I have saved this target, I will invest any excess in a term deposit. When it is time to eventually retire, I will increase my emergency fund to one year’s worth of living expenses. I will invest year two and three’s cash reserves in a rotating one year and two year term deposit. This ensures I will always have access to one year’s worth of living expenses in cash as an emergency fund.

My strategy is not written in stone – it will evolve as I read and learn more from the existing FIRE community and the retirement literature out there.

How do you prepare for sequencing of risk?

Disclaimer: Nothing I write here should be construed as financial advice – these are my opinions only and how I personally manage my money may be vastly different to how you manage yours. Please seek professional financial advice should you need it. 

6 Replies to “Emergency fund & sequencing of risk”

  1. The healthy cash based emergency fund at retirement is definitely important! Given your time frame as well, this strategy is quite appropriate. Because I’ve got a much longer time frame I’m doing it the other way around, in the sense of already having a 6 month fund, and planning to maximise investments for the moment, and shift back to a plan similar to yours when I’m closer to my FI number. Definitely no intentions of “pulling the plug” until I have that cash retirement emergency fund though!

  2. Interesting post. A few years ago I did have a year’s worth of expenses in a cash ISA for a long time but with interest rates plummeting I started to move most of it into my S&S ISA. I currently have a three month emergency fund and figure that if three months of unemployment turns into more, I can start selling shares. But yes, when, and if, I reach FIRE, a 12 months or more cash reserve makes sense. I may, on reaching FIRE, see if my S&S ISA can accommodate me selling enough shares to create a three-year EF.

  3. I basically don’t want to sell my shares if it’s a bear market so I’m starting to save a little bit towards this cash reserve. I’m definitely investing more in the share market than holding cash at the moment. I will divert more income towards cash the closer I get to retirement.

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