When Is the Penalty for Holding More Years of Expenses Greater?

One of the questions retirees often face is: Should I keep 5 years of expenses in my retirement bucket, or 20 or even 30 years?

My simulations suggest that the answer depends largely on the expected spread between equity and debt returns.

When the spread is large—for example, when equities are expected to return 9% and debt 1%, or equities 7% and debt 1%—the penalty for increasing the bucket size is much higher. Every additional year of expenses held in debt means giving up a larger amount of expected equity growth. As a result, the required debt allocation rises more rapidly as you increase the bucket size.

On the other hand, when the spread is small—for example, when equities are expected to return 7% and debt 5%, or even 4% and 4%—the penalty for holding additional years of expenses is much lower. The opportunity cost of holding debt is reduced because debt returns are closer to equity returns.

In this context, the penalty refers to the increase in the required debt allocation as you move up the years-of-expenses ladder.

For retirees deciding how many years of expenses to keep in their bucket, expected market returns may be just as important as risk tolerance. If you expect a narrow equity--debt spread, maintaining a larger bucket may be far less costly than otherwise.