Having cash in the bank that you can use at any time offers some safety. While the S&P 500 can drop by 20% during a market correction, your money will retain its nominal value. However, that sense of safety comes with a cost. The real value of your money will quietly drop over time due to inflation.
A $100 bill got you a lot further in 1980 than it did today, and the same can be said when comparing current prices to those in the 2010s. While it’s important to have some accessible savings, it’s also essential to invest your money so it grows.
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Why retirees gravitate toward cash
Retirees often gravitate toward cash because there is no volatility with this asset. It’s more predictable than putting your money into the stock market and wondering what the balance will be in three years. Some retirees yearn for predictable outcomes more so than young investors because these individuals often have to withdraw from nest eggs instead of building their income with steady paychecks. They also don’t have as long of a time horizon for their balances to recover from a market downturn.
Older investors also remember more of the downturns, such as the dot-com bubble of the late 1990s and early 2000s, and the Great Recession from 2007 to 2009. Many younger investors didn’t have to invest in those economic environments, which can make them more comfortable with taking risks. While it’s a good part of any retirement strategy to have some cash to cover expenses, this same perk becomes a problem if you opt to save too much cash.
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The hidden costs of holding too much cash
A $100,000 balance will remain a $100,000 balance if you don’t add or deduct from it. You can even earn interest on your money without taking on risk. However, the annual percentage yields (APYs) on traditional savings accounts don’t tend to outpace inflation, especially when considering that interest is treated as ordinary income for tax purposes.
The $100,000 you have saved up may not buy as many products and services over the next five to 10 years as it can afford you right now. Not only does cash slowly lose purchasing power, but keeping cash on the sidelines means you’re risking missing out on long-term investment growth.
It’s still important for retirees to invest over the long run because retirement can last multiple decades. Some people retire at 60 and live into their 90s. Investing is one of the few ways to beat inflation and give yourself more financial flexibility deep into your retirement years.
How to balance safety and growth
Wealth preservation becomes more important in retirement, but if you exclusively play defense, your cash will slowly lose purchasing power due to inflation. The bucket strategy uses basic math to create a balance between these objectives. It involves setting aside money for short-term expenses, medium-term conservative investments and long-term growth investments.
The exact amount of money you should keep in each bucket will depend on your goals, risk tolerance and time horizon. But here’s a general guideline. The first part of the bucket strategy is to have enough idle cash to cover one to two years of living expenses. Then, you can invest the second bucket in conservative vehicles such as bonds for years three to 10 of your retirement. The last bucket can be invested in stocks so that your money will grow beyond that.
