- Everyone should hold at least three to six months' worth of their expenses in easily accessible cash
- If you are retired, in some cases it might make sense to hold more
- Inflation erodes the value of cash, so don't hold more than is appropriate for your circumstances
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Everyone needs some cash in their portfolio, and advisers generally suggest having three to six months’ worth of your expenses in easily accessible accounts. This is to cover unexpected events, emergencies such as a boiler breakdown, being made redundant, a substantial rise in your mortgage rate, and large unplanned expenses such as a last-minute holiday or car purchase on a whim.
Having the cash ready means you don’t have to take out debt, forego a purchase or – crucially – sell investments at short notice when their value has fallen.
Selling investments when their value has fallen means that the remaining, smaller amount has to work harder to get your portfolio’s value back to where it was. For example, if a £100,000 portfolio falls 10 per cent in one year and rises 10 per cent in the next, its value will only reach £99,000. If this is part of your retirement income, it could result in you running out of money before the end of your life.
Having a decent level of emergency cash is particularly important if you’re self-employed or run a small business whose cash flows and revenues have a cyclical element, especially in times of recession because these might reduce at the same time as the value of your investments falls. If your cash flows and revenues are variable, consider holding up to a year’s worth of your expenses in cash.
If you have planned large expenditures coming up, such as work on your home, replacement of a car, a house move or gifts to children or grandchildren, hold cash in addition to your emergency fund to cover this – if your income doesn’t. A key reason to hold a large cash reserve within your pension pots is if you are going to buy an annuity rather than go into drawdown. This is so that a fall in markets doesn’t reduce the money you have set aside for this just before you do it.
Retirement
If you’re retired and your investments contribute to your annual income, advisers suggest having up to three years’ worth of your expenditure in easily accessible cash. This is because you might be on a lower income and, as you aren’t earning, may not be able to build up savings again after you use them.
However, if a good deal of your retirement income, or at least an amount that covers your basic day-to-day expenditure is from very secure sources – state and defined-benefit pensions, and annuities – having a very large cash reserve is less urgent. Also, if maintaining a cash reserve means that you have to draw on taxable sources of income such as pensions, it is probably better to draw from cash and have a lower reserve.
If you have more than enough secure income and/or assets to cover all your anticipated spending requirements for the rest of your life you might not need to take a lot of investment risk so could hold a higher level of cash. Ian Cook, financial planner at Quilter, adds that you could temporarily have a higher cash allocation at the start of your retirement as you settle into your new lifestyle and see how much your monthly expenditure is.
Cash is also useful for bridging short-term needs. For example, you retire at age 65 and receive annuity income of £10,000 a year but won’t start to receive the state pension until 67. However, your expenditure is about £20,000 a year so you could hold the money you need to meet the shortfall in cash.
Inflation erosion
Returns on cash are relatively low, and even when it’s generating more attractive rates of interest it is still unlikely to be as much as inflation. And when inflation comes down, interest rates almost certainly will as well. “It's pretty certain that if you hold significant levels of cash, the real value of your assets will go [down] in value,” says Michael Lapham, director at Mercer & Hole.
This means that you will lose future purchasing power in real terms. Even if you want to just preserve the value of your assets over the long term you will need to invest them, so only hold cash in addition to your emergency fund if you are going to spend it in, say, the next three years.
