How to Manage Unplanned Expenses During Retirement

The traditional financial-planning prescription for life's financial emergencies is to hold three to six months' worth of living expenses in cash.

But how should retirees handle unplanned expenses? Should they also have an emergency-fund cash cushion on hand, or should they simply increase their withdrawal rates when they need to and then tighten their belts at a later time?

With an eye toward unearthing some best practices on how to handle unplanned expenses during retirement, I turned to the Investing During Retirement forum of Morningstar.com's Discuss boards.

Not surprisingly, our healthy contingent of retired posters had already given this question considerable thought, and many worthwhile strategies poured forth. Some retirees have carried on with the traditional rainy-day fund in retirement, while others have attempted to factor in unplanned expenses into their withdrawal-rate projections. Several advised that with some advance planning--putting a time horizon on new-car purchases, for example--it's possible to circumvent unexpected expenses.

To read the complete thread or share your own in-retirement strategy for managing unplanned expenses, click here.

'The Old-Fashioned Rainy-Day Fund'
Several posters stated that there's no need to reinvent the wheel; unplanned expenses should be anticipated and addressed just as they were during the working years--by maintaining a liquid reserve that can be tapped in a pinch.

For steelpony10, that means "a cash reserve of uninvested money for nonroutine and unpredictable expenses. The old-fashioned rainy-day fund. It's been around for years. The same thing people should have when they weren't retired."

Bobk47 noted that he and his spouse haven't had to tap their emergency reserve to date, but it's there if they need it. "We do have an emergency fund that I pretty much just keep in an FDIC-insured account. It isn't earning anything but I know it will be there in an emergency."

Festus is also a believer in setting aside extra for the inevitable unexpected expense, writing, "In retirement it really is all about having enough money and being able to stay ahead financially, regardless of what comes along the way. I have a savings bucket to cover the unexpected surprises that seem to appear from time to time, no matter how prepared you think you are, they arise from nowhere."

Richendric and his spouse maintain two liquidity pools. "We have owned a home for 40 years and always had a 'maintenance accrual' account for large unplanned expenses on the home. For real emergency expenditures not covered by insurance, such as acts of God, personal accidents/health related issues, and emergency cash for children (already had one of these), we would use our cash reserve."

Yet even as many retired posters agreed on the merits of rainy-day funds, they differed in terms of the optimal size as well as what to put into them. One common prescription? Three years' worth of living expenses in an account that mixes true cash with short-term bonds.

Marcos wrote, "We have a rainy-day bucket in the form of three years of cash needs in money market, short-term bonds, and certificates of deposit, which would be available for unforeseen expenses."

JHAsheville's liquidity bucket is of a similar size and composition: "Buckets work well for us with three to four years in tax-exempt money market and plenty of short-term bonds could make up for a dire emergency."

But other retired posters noted that there can be a steep opportunity cost associated with holding too much in cash and cashlike instruments, particularly as yields have shriveled up.

Rule72 has taken action. "This past year I've modified my approach to managing cash flow due to the low returns of CDs and money markets. I keep a minimum balance equal to about one month's expense's in the brokerage core account into which any income also flows daily. This core account basically pays nothing in interest. I then use a short-term muni-bond fund Wells Fargo Advantage Short-Term Municipal Bond that I sell shares of as required each month to cover any short fall. I may have unexpected expenses, but I don't have 'emergencies' in the sense that one should have an emergency fund. Prior to this change I kept about six months' money for 'emergencies' in a money market account."

DennyF, like many other retired posters in the thread, noted that anticipating upcoming "extras" can help determine how much to hold in reserve. "So far, our emergency fund has been adequate for our needs during our eight years of retirement. I try to forecast repair and replacement expenses for the next two to three years and budget accordingly. I don't think I'm anal about this, but wife would probably disagree."

When SlowMoe's unexpected/emergency bucket gets too large, he and his spouse take the money and run. "When my wife and I were both working we kept a cash account that was available for unexpected or emergency spending. Toward the last few years before retirement we kept it at about 20% of our annual gross. Since retirement we keep the fund at about 3.5 times the pre-retirement amount. We have had no unexpected expenses before retiring and none in five years of retirement. The account has basically become a savings account; when it gets up to 4 or 5 times the amount we had before retirement we splurge and take a nice vacation somewhere." ​

'The Important Thing Is to Have a Plan'
But not every retired poster is convinced of the need to maintain a separate fund for liquidity.

Taylor Larimore, a proponent of the less-is-more approach to portfolio planning, just doesn't see the need for most retirees. "Pat and I are in retirement with an adequate portfolio for the years ahead. We have no need for a separate low-return account that may never be needed. If an unexpected expense occurs, we will simply withdraw what's necessary from our portfolio. Younger investors, without a ready source of immediate cash, obviously benefit from a separate emergency fund. Nevertheless, it is a myth that everyone needs to maintain a separate emergency fund."

Povdds is similarly common-sensical; managing in the face of expenses needn't require a lot of fancy planning maneuvers. "I don't think there is so much difference between an unexpected expense while working or while retired. When we had unexpected expenses during our working years, we had to examine our situation and our resources, prioritize, tighten our belts where needed, and forgo some less-important expenses."

A healthy contingent of posters noted that they've aimed to incorporate upcoming big-ticket expenditures into their cash-flow projections. Withdrawing less than their "safe withdrawal rates" in some years lets them take out more in others.

ColonelDan accommodates unplanned expenses "by spending less than my safe withdrawal rate and keeping the balance invested. Thus far, I've averaged a withdrawal rate of 2.5%, and that includes two new cars, a new central air-conditioning system, and multiple expensive trips."

WOODJ's withdrawal rate also accounts for the fact that income needs will tend to ebb and flow over time. "There shouldn't be many unforeseen expenses in retirement. We will need a new heating or air-conditioning systems someday. We will have a big medical or dental expense. he roof will need replaced. We will buy a new automobile or two. I tried to plan for those. To cover those special expenses, I don't spend all of my 4.5% average annual withdrawal budget. What I don't spend is set aside (and continued invested conservatively) to cover that someday new roof, hearing aid, and auto. In 14 years of retirement I haven't had an 'unforeseen' moment that required more than that. If I did, I could handle that, but I would just try to spend less going forward to catch up. I should add that adequate insurance is important to cover medical and disaster recovery."

Playbook agreed that good cash-flow projections should incorporate out-of-the-ordinary income needs that are bound to crop up. "I have cash-flow spreadsheets that I use to forecast well into the future. I know we'll need replacements for HVAC, roof, cars, appliances, and these are planned in the spreadsheets. If we discuss remodeling the bathroom, or planning an expensive vacation, for example, I insert these estimates in the spreadsheet and instantly see the effect. Some things like the roof or HVAC are musts. Other discretionary expenses, if they make too much of a dent in a particular year, may have to wait, or get moved to another year. The important thing is to have a plan of income and expenses by month/year for several years in the future and to be as realistic as possible about both."

For poster kbisles, taking regular stock of income and expenses is essential to making this type of strategy work. "My wife and I live one day at a time, with a monthly financial evaluation. We track are spending daily and at the end of each month we have expenses. The expenses are always paid in full and then that monthly figure is calculated for what is needed for that month one year from now. Thus, we always have a new annual budget each month relating to expenses, if the monthly income does not cover the expenses then we take it from our principal/investments of not more than 5% annually. Sometimes we spend less, sometimes more than previous annual month. It usually averages out pretty well."

Yet Vandy73 lamented that anticipating each and every expense is easier said than done. "I do an expense spreadsheet now, but it's not much good until year end when I take the time to evaluate it. It has quite a few 'unexpecteds' in it, as I budget for my regular expenses, but then an insurance premium or property tax bill comes in and blows the monthly budget to h*ll, so I have to pull out of longer-term savings, which thankfully we have."

MtHood thinks that proper budgeting can take care of the problem, incorporating both ongoing expenses as well as those that are lumpy. He advised, "A simple retirement budget should ideally contain at least three categories: 1) What you know you are going to have to spend (for example, food, utilities, gas for the car, real estate taxes, insurance costs, and so forth); 2) What you may or may not spend the full amount of in the year (for example, car maintenance, home maintenance, insurance deductibles, gifts, vacations, entertainment, and so forth); 3) What you know you are going to have to spend some time but when you are not sure (for example, the new roof for the house, the new car, a daughter's wedding, and so forth)."

JHAsheville's strategy has been to get some big-ticket expenditures out of the way before retirement. "We're starting second year of retirement. Game plan was to have most big ticket items done before and paid off such as a big renovation with new HVAC system, much-needed retaining wall and a replacement deck (old one had a foundation issue). We know 'future' needs will be a new car."

Some posters noted that they look for their investments to kick off extra income and/or returns, which they can turn to in a pinch.

Retiredap shared, "For some recent dental work, I paid the balance, after insurance, with a rewards charge card and then paid the charge bill from accrued IRA profits and dividends. After four years of retirement, we have not had to touch principal." ​

Cyrusandmag uses overage from required minimum distributions to cover unanticipated expenses. "My RMD is much higher than our annual expenses. This excess is placed in a municipal bond fund which would serve as a source for high, unexpected expenses."

Jomil fills up his liquidity bucket with dividend distributions. "I use a tax-exempt money market brokerage billpay, direct deposit, and checking account with a sufficient balance to cover routine and some unforeseen expenses. Dividends from the taxable account are directed there. When the balance is larger than I expect to need in the short run, I reinvest the difference. I can always sell shares in a pinch, but prefer not to generate unplanned capital gains."

'It's My Backup Plan'
Health-care costs can be some of the largest unanticipated expenses during retirement. But several posters noted that their insurance programs had prevented those expenses from getting too far out-of-hand.

Health savings accounts--whereby one contributes to an investment account that can in turn be used to defray health-care costs before and during retirement--received several shout-outs as useful tools for keeping health expenses down.

Festus, for example, uses an HSA alongside an emergency fund. "My HSA covers the health problems, and the savings bucket takes care of all the rest of life's surprises."

Playbook uses a combination approach to make sure that his household's health-care expenses don't go too far off the rails. "I'm retired with Medicare and Medicare supplement coverage. What Medicare doesn't cover, the supplement does. My wife has a high-deductible health plan with a maximum out of pocket of $2,800. Just in case, though, we keep about $30,000 in the health savings account."

Other posters noted that they're taking the belt-and-suspenders approach to dealing with unplanned expenses. In addition to building a cash fund and being willing to tighten their belts in a pinch, they've also established cheap sources of credit that they could turn to in a pinch.

Many posters noted that they like the security blanket of knowing they could tap home equity after exhausting other resources.

Marcus, who also maintains liquid reserves, wrote, "We also use a home equity line of credit for large expenses; the tax-deductible interest is 2.5% and we generally pay off any home equity loans within a year; the interest paid is cheaper than paying income tax on a larger IRA distribution."

NormanR hasn't tapped his HELOC, but it's there if he should need it. "I have an equity loan (line of credit). It's my backup plan. It currently has a $0 balance and will remain available for another 10 years. If I should borrow against it, it will remain available for another 20 years. It has no annual fees, etc."

Yet as valuable as it can be to plan for the unexpected, several posters noted that it's impossible to plan for every exigency.

Hondo noted that emergency expenses will still crop up, try as we might to predict them ahead of time. "No one can foresee all emergency expenses. We just have to prepare as best as we can," this poster advised.

FidlStix agreed. "There are those one-off expenses with an "in-" attached, as in "insurmountable"--a $1 million judgment or a catastrophic illness that stretches our insurance way past the breaking point. We hope to avoid those by living well and taking care of ourselves."

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