Every logical plan has a starting point and an end goal, and this reasoning is applicable to Financial Planning. Particularly when I work with prospective new clients, the starting point of our analysis is to establish a strategy for emergency funding. Until a household is ready to navigate through tough times, it is generally not prepared to begin investing more broadly. Each household should have an emergency fund.
HOW MUCH IS TOO MUCH (OR TOO LITTLE?)
In personal finance, the most common advice that can be found regarding an emergency fund is to accumulate six months of living expenses in cash. This money can then be accessed during emergencies (job loss is most typically contemplated, though this can also apply to medical needs or other times of urgency). The “six-month” axiom is the traditional baseline for good reason; it provides enough runway for most families to navigate a hardship. However, in developing a plan there are other factors that can be taken into consideration regarding the size of an emergency fund.
Primary among these is whether the fund is to protect a family or a single person. An individual should plan to have a six-month reserve in cash in most cases. For a married household where both spouses work, the likelihood of each job loss can be taken into consideration. Some professions are more resistant to job loss during a recession, for example. The real question is the likelihood that both spouses would be unemployed at the same time. If this is unlikely, then a reserve of less than six months may be acceptable. If this is reasonably possible, then an eventual goal of saving an emergency fund greater than six months may be logical. In practice, once factors are weighed out, I find that many two-income households are comfortable with a reserve between three and six months. Some households (such as those with highly variable income such as commission-based) land on a goal closer to one year.
Though uncommon, another reducing factor may be any guaranteed income which would continue during an emergency. This could include an alimony payment, ongoing pension or disability income, or unrelated part-time income. A six-month fund could be reduced by this expected net income.
CALCULATING YOUR EXPENSES
While it is optional, one of the first things which I ask a new client to do is fill out a budget. This is never done to attempt to put someone on a budget, and the primary purpose is to make sure that we both understand what someone has as lifestyle needs. We then use that budget to formulate an emergency fund.
If you don’t have a budget but would like to save for an emergency, the most simplistic approach is to save six months of NET income. After all, following a job loss many items withheld from paychecks—such a tax withholdings or retirement plan contributions—do not need to be budgeted for.
A multiplier can then be applied to your net income. How much could you live on if you trimmed your spending modestly after a job loss? 75%? 85%?
For example, assume that your paycheck is a NET deposit of $1,800 every two weeks (twenty-six paychecks per year). Out of that, you place $300 per paycheck into a savings account.
For monthly cash flow purposes, this means that you live on the remaining $1,500. If you assume that you could cut spending a little and live on 85% of that remainder, you need an emergency fund of $16,575 ($1,500 x 13 paychecks x 85%). While I think developing an actual budget can lead to more precise goals, this can give you a baseline to save for.
SAVE IN STEPS
For a married couple with two incomes, a six-month nest egg can be daunting.
While it varies widely between households, I typically see the target between $40,000 and $60,000.
Such a number may look impossible if you don’t have any savings to start.
My advice is always to break this into smaller goals.
If $40,000 is your targets, focus first on a one-month emergency fund (which I would round down to $6,500).
This may not get you as far through an emergency as you would like but it will get you a lot further than zero.
It is also important to keep in mind that that this goal need not be accomplished in a vacuum.
Most households have multiple fiscal goals.
In financial planning, one of the things which I do with clients is establish a broader agenda.
Depending on their goals, situation, comfort with risk, etc., households will frequently decide to work on some degree of emergency saving in tandem with some degree of debt reduction (or attention to other goals).
TYPE OF EMERGENCY ACCOUNT
In discussing an emergency fund, one of the most common pieces of feedback that I get is that six months of someone’s income is too much to have built up in unproductive cash. It is then suggested that maybe the client should invest the emergency fund. While, in the end, it is the client who must make that decision, my preference is to dissuade a household from investing “emergency” money.
To justify this, I like to walk clients through the tandem movement of labor force participation and the S&P 500 index during the great recession. By the time that layoffs (a lagging indicator) started showing up in labor data in early-2008, the stock market had already declined roughly 10%. By the time that median layoffs were reached about ten months later, stocks were down 25%. By the time layoffs had statistically stopped, the stock market was down approximately 50%. Anyone who got laid off during the tail end of this period not only got their pink slip but, through stock losses, likely saw their “six-month” emergency fund cut down to three right when they needed it.
Thus, my preference is for a household to carry at least half (if not all) of its emergency fund in cash.
More directly, for practicality’s sake, I prefer to see clients split this emergency fund into two cash halves. The first half (typically three months of spending) is the true “emergency fund” and should be held in its own account (such as a one-year bank CD). Some clients who fear they “can’t trust themselves” prefer to hold this portion at a separate bank (to create extra steps to access it).
In my view, it is okay for the other half of the emergency fund to serve as regular put-and-take savings. This is held in a savings account which the household can access occasionally for lifestyle needs as long as the account gets paid back. It helps clients to graduate from credit cards to “being your own bank”. For households with no nest egg, we go through building this “half” first.
If this portion (the other three months) wasn’t somewhat accessible, which is what some financial planners would argue in favor of, then households would need to have a savings account on top of six months of emergency saving. In my view, this gets to be counter-productive after a point as cash saving is one of many financial goals for a household.
APPLICATIONS FOR RETIREMENT
Conceptually, once someone is ready to retire, they may not need an emergency fund. After all, is there a remaining concern for job loss if you have already stopped working and begun living off assets? Rather than becoming unnecessary, I prefer to think of the nature and purpose of the account changing.
There are different ways that households set up retirement distributions—with enough variation that I can’t cover it here in any serious dimension. I will simply get across the concept that the most common withdrawal strategy for retirement among my clients is to take a baseline monthly distribution to cover true lifestyle expenses: utilities, groceries, vehicle costs, etc. Clients will then, typically, pay for items such as vacations out of their large savings account. During periods where the stock market is elevated, we will seek to replenish that savings. Cash plays the new role of acting as a buffer to help prevent ever having to sell investments at a loss to take a vacation.
Building up an emergency fund can be daunting—and may even seem complicated to those with modest financial knowledge. At Liberty Tree Asset Management, I offer a free financial plan to any prospective client who wishes to put a strategy in place. You do not need to have a high net worth to have a financial advisor. In fact, in many cases I would prefer to work with somebody who needs help building an emergency fund. I know that these are often clients who are ready to take their finances seriously.
Putting an emergency fund in place can also be a lengthy process. The key is to get started. If you have no other motivation, imagine how easily you will sleep once that cash is in the bank!
Anthony (Tony) Sueck
Retirement Income Certified Professional (RICP)™