Retirement is the point when your investments need to do more than grow. They also need to help pay your bills, ideally without forcing you to sell shares at the worst possible time.
After years of investing, you might have a portfolio built for long-term growth. But a market crash just before or after you stop working could put pressure on your plans.
You don’t necessarily need to sell everything and move into cash. Instead, use your final working years to build a buffer and prepare your portfolio for withdrawals. Here’s how.
1. Work out how much cash you’ll need
Start with your expected annual retirement spending, then decide how much you want to have set aside in cash before leaving work. A buffer covering 1-3 years of expenses is a useful starting point, but the right amount depends on your circumstances and appetite for risk.
If you expect to spend $50,000 a year, that means:
- One-year buffer: $50,000
- Two-year buffer: $100,000
- Three-year buffer: $150,000
The idea is to cover living expenses during a market downturn without being forced to sell investments while their value is down.
There’s a trade-off, though. Cash offers stability and easy access, but generally has less long-term growth potential than shares. Holding too much for too long can make it harder to keep pace with inflation.
Think of your buffer as insurance against a bad run in the market, not a replacement for growth investments.
2. Understand why timing matters
Imagine you retire with an $800,000 portfolio. In your first year, the market falls by 25%, reducing its value to $600,000 before withdrawals. If you then withdraw $40,000 for living expenses, you’re left with $560,000.
Someone with enough cash set aside to cover those expenses could draw on their reserves instead, leaving their shares invested while markets recover. This is known as sequence of returns risk: the danger that poor returns early in retirement will have a disproportionate effect on how long your money lasts.
Two investors can earn the same average return over time but end up with very different outcomes, depending on when losses occur. This is particularly relevant to early retirees, whose portfolios may need to support them for several decades.
A buffer won’t eliminate market risk, but it can give you more flexibility during a downturn.
3. Build your buffer before you stop working
It’s often easier to build a cash reserve while you’re still earning an income. Rather than trying to assemble the whole amount after retiring, direct some of your salary towards it in your final 1-3 working years.
You could use:
- New savings: Set aside a portion of your income each month.
- Cash dividends: Consider taking distributions in cash instead of reinvesting them.
- Maturing term deposits: Direct some maturing funds towards your reserve.
- Existing cash: Allocate money you can comfortably spare without compromising your emergency fund.
Keep your buffer somewhere appropriate for money you’ll need to spend soon, such as a savings account or staggered term deposits.
Other defensive investments, including bond ETFs, can play a role in your allocation but aren’t equivalent to cash. Their values can fall, too.
4. Put your dividends to work
If you automatically reinvest your dividends, changing that setting can be a simple first step towards building your buffer.
Dividend reinvestment plans (DRPs) use distributions to buy additional shares or ETF units. This can be an effective way to compound your investments during your working years.
As retirement approaches, consider switching off reinvestment for some or all eligible holdings and receiving distributions in cash instead. On Pearler, for instance, you can adjust dividend reinvestment settings where supported. You can then direct the cash into an account you’re using to build your retirement reserves.
Dividends aren’t guaranteed, and payments can vary. Still, redirecting them can help build your buffer without immediately selling existing investments. It also gives you a clearer picture of the income your portfolio generates. Remember that dividends are only one part of your total investment return.
5. Rebalance without an unnecessary tax bill
If your portfolio is heavily weighted towards shares, you might want to move some money into cash or defensive investments. Selling shares that have increased in value, however, can trigger capital gains tax (CGT).
One alternative is to direct new savings and cash distributions towards defensive assets instead of selling existing holdings. Over time, this can shift your overall allocation while deferring capital gains. The limitation is that the process may be too slow if your savings are small relative to your portfolio. Selective selling could still make sense.
Before selling, consider how the gains will interact with your other taxable income. Spreading sales across financial years may also be worth investigating.
And don’t assume that selling after retirement will automatically be more tax-efficient. The outcome depends on your circumstances, so consider speaking with a registered tax agent before making significant changes. The goal is to sell strategically while understanding the potential tax implications.
6. Practise living on your retirement budget
A carefully calculated portfolio won’t help much if your spending estimates are unrealistic.
Try living on your expected retirement budget while you’re still working. If you currently spend $90,000 a year but expect to need $60,000 in retirement, practise living on the lower amount and direct the difference towards your buffer. This helps you check whether your budget accounts for irregular expenses. It also shows how much you can realistically save before leaving work.
If the budget feels too restrictive, you can reconsider your retirement date or spending while you still have an employment income. If it feels comfortable, you’ll have practical evidence that your plan may be workable – and extra savings to show for it.
7. Plan for the gap before you can access super
In Australia, many people can’t access their super until age 60, subject to the applicable conditions of release.
That means that if you’re retiring earlier, you’ll need to fund the intervening years using accessible assets, such as cash and investments held outside super, alongside any other income sources. Someone retiring at 55 has a different funding challenge from someone retiring at 45. The longer the gap, the more important it is to model your cash flow over time rather than relying on a single buffer target.
Consider how your accessible assets and super fit into your overall retirement plan.
Your pre-retirement checklist
Before leaving work, make sure you’ve:
- Estimated your annual retirement spending
- Set a realistic cash buffer target
- Calculated how much you need to save each month
- Considered redirecting dividends instead of reinvesting them
- Reviewed your asset allocation
- Checked the potential CGT consequences of selling investments
- Tested your retirement budget while still earning
- Planned for the period before you can access super, if applicable
You don’t have to make every change at once. Start by calculating your expected spending and the gap between your current reserves and your target buffer.
Prepare your portfolio for life after work
Early retirement calls for a portfolio that can withstand market downturns while still growing enough to support you over the long term.
Building a cash buffer can help you prepare without immediately selling investments that have grown in value. Testing your retirement budget can also reveal problems while you still have time to adjust.
You can’t predict a market crash, but you can prepare for one before leaving work.
Disclaimer: This article is general in nature and does not take into account your individual objectives, financial situation or needs. The cash buffer strategies and examples are illustrative only, and the appropriate approach to reducing investment risk will depend on your circumstances. This article does not constitute financial, tax or superannuation advice. Before changing your investment allocation, selling assets or making decisions about your retirement, consider seeking advice from a qualified financial adviser or registered tax agent.
