Retirees lack emergency savings to cover unexpected annual expenses

When assessing how much income you will need to cover your living expenses in retirement, remember to take into account how you will cover unexpected costs.

More than 8 in 10 retirement households – 83% – will face unexpected expenses in a given year, according to a new study from the Center for Retirement Research at Boston College. Among households facing unexpected expenses, the average annual amount spent during retirement is $6,000. Measured differently, the typical household will spend an amount equivalent to 10% of its annual income.

Yet many households don’t have this emergency savings, according to the study. While about 58% have enough cash on hand to cover a single year’s unexpected costs, about 16% would have to use their 401(k) or other retirement accounts and the rest – about 27% – wouldn’t be up to it even after using up all their cash and retirement assets.

“Approximately 40% of (retiree) households do not have enough cash flow to cover even a single year (of unforeseen expenses), let alone their entire retirement,” the study notes.

The research uses data from 3,427 retired households that participated in the 2000-2020 Health and Retirement Study and the Consumer Affairs and Activities Mail Survey, both from the University of Michigan.

While experts generally recommend non-retirees set aside three to six months of living expenses as emergency savings in case of job loss or other financial shocks, that amount may be different for retirees — who must figure out how to stretch their savings over what could be a decades-long retirement.

As many retirees struggle to keep pace with prices that continue to rise, accounting for unexpected expenses is an important part of assessing retirement readiness.

“It helps you plan your cash flow relative to your income needs,” said Anqi Chen, co-author of the report and associate director of savings and household finances at the Center for Retirement Research.

Although some households may struggle to put money aside, “even small amounts of savings will help provide some sort of buffer when these events occur,” Chen said.

Expenses are separated into three categories in the research:

• “Rainy day” expenses, such as maintaining a car costing more than $500 or maintaining a home costing $1,000 or more.
• Family-related expenses, such as the death of a spouse or financial assistance to the family.
• Health care expenses over $500, such as dental or prescription costs.

The Center for Retirement Research estimates that 60% of all retirement households will face a shock from bad weather; 29% will have an unexpected family expense; and 58% will face unexpected healthcare costs.

According to the study, retirees with higher incomes experience these unexpected expenses at a higher rate than those with lower incomes. For example, about 45% of households with incomes below $50,000 experience a health problem or problem in a given year, compared to 80% of those with incomes of $100,000 or more.

“This finding highlights that households have some control over the timing and amount of their spending,” the report notes.

So how much should you have saved? Depending on the retiree’s individual situation, financial advisors may recommend spending anywhere from three or six months to a few years – or a variation of these parameters. Much of this will depend on your individual situation.

“What we usually tell clients is to think less in terms of months of expenses and more in terms of access to cash for surprises — health care costs, home repairs or family needs,” said certified financial planner Joon Um, a tax advisor at Secure Tax & Accounting in Beverly Hills, California.

“For many retirees, that amounts to a year of basic expenses, adjusted for guaranteed income like Social Security or pensions,” Um said.

The right amount depends on health, housing, income stability and flexibility of other assets, Um said.

“Retirees with stable income and liquid portfolios may need less cash, while those with higher medical risk or less flexibility need more,” Um said. “The goal is not to maximize liquidity. It’s about having enough to avoid selling long-term investments at the wrong time.”

In other words, if you don’t have enough cash set aside, you may be forced to sell investments when the market is down.

However, having too much cash carries its own risks, said Peter Lazaroff, a chartered financial analyst and CFP, and chief investment officer at Plancorp in St. Louis.

“Any time a retiree has more than two years of cash expenses, it’s too much,” Lazaroff said. “From a purely mathematical point of view, you’re giving up too much yield.”

The biggest risk to your cash flow is inflation, he said. The latest reading of the Consumer Price Index showed an annual inflation rate of 2.7% in December.

“Your money loses value every year,” he said. “You are putting your purchasing power at risk.”

He recommends stashing your money in a high-yield savings account — which currently typically earns more than 3% interest, according to Bankrate — to help minimize the impact of inflation.