We all know we are supposed to have cash for a rainy day. Things happen and you want to have cash (and cash equivalents) that you can access quickly and have certainty that it will be there. Many “financial gurus” focus on having emergency funds to avoid checks bouncing or needing to run up credit card debt. But what about those that have enough money that these aren’t issues and are thinking about where and how much to invest it? You probably don’t want to have to sell your stock portfolio right after a market crash when prices are at its lowest or dip into your 401(k) and potentially incur early distribution penalties. And you certainly don’t want to have to dramatically change your lifestyle when you have a short-term financial blip just to keep your wealth invested.
Conventional Wisdom – The Incomplete Advice for the Masses
The National Foundation for Credit Counseling defines an emergency funds as 3-6 months of income saved. Why is this conventional wisdom based on income? If I follow this advice and make four times as much as I spend every month, I will have a four times larger emergency budget than someone who lives paycheck to paycheck, even if we spend the same amount every month. Would I want that?
Other financial gurus have a variation on this theme, but focused on expenses. Best-selling author Dave Ramsey advises 3-6 months expenses. Suze Orman asserts having eight months saved in The Laws of Money, The Lessons of Life, and years later expanded the range to a year.
This makes for a big range. If a person has expenses of $150,000 per year, the difference between three months and one year is $112,500. If that money is invested in the stock market at say 8% return per year, that difference would be worth almost $525,000 in 20 years. In this theoretical example, $525,000 20 years from now represents the opportunity cost of an oversized emergency fund.
As with much broad sweeping financial advice, these rules of thumb are a good start, but designed for the average person. Nobody is the average person. Everyone’s individual needs are different.
A Better Definition of “Emergency” in Emergency Fund
Instead of guessing your target emergency fund amount based on a rule, let’s look at what an emergency fund is used for and figure out how much you need from there. The emergency fund is a safe pile of cash that essentially provides insurance to protect against short-term future cash flow needs. In this discussion, we will focus on how to do this for people currently generating income (called accumulation stage in our industry). Those in retirement (distribution stage) have a different set of needs and will be covered in a future blog.
For the accumulation group, cash flow can suddenly change for the worse in two ways: sudden loss of income or sudden increase in expenses. Remember that an emergency fund is designed to cover you for a short period of time if something unexpected occurs without having to liquidate investment assets. Permanent changes to your situation will require strategies beyond what your emergency fund would accommodate. Let’s focus on four key steps to sizing your emergency fund need:
Emergency Fund Sizing Step #1 – Assess Your Living Needs
Income covers living expenses, and the excess is used to accumulate wealth. Therefore, the first thing you need to do is not figure out what you make, but what you spend. You then need to decide if and/or what in your lifestyle would change in an emergency. The answer to this question is highly personal. To get started, ask yourself a few questions:
- Do I have expenses that I cannot get rid of even if I lose my job? Think housing, car payments, alimony, child support, etc.
- Do I want to change my lifestyle if my income situation changes? Would you stop shopping at Whole Foods and instead turn to Food Lion? Would you limit how much you eat out or what clothes you buy or what type of gifts you buy for others? Would you suspend piano lessons or tutoring for your children? Would you suspend magazine subscriptions or cable TV?
- Are there expenses in my life that I could defer until my situation improves? Think new furniture, a new car, vacation, etc.
If you already work with a financial planner or use a budget service like Mint, you may already have a good handle on how to answer these questions. Conventional wisdom advises to use income to calculate emergency fund targets for those that don’t know their living expenses needs, but the cost of this shortcut is many times an overfunded emergency fund.
Emergency Fund Sizing Step #2 – Assess How Long You Could Be Without Income
The next consideration is how long you expect to have a loss of income if the situation arises. Are you in a profession where if you lost your job, you could find a new job quickly, or do you expect a long job search? Do you want to be in a situation where you take a suboptimal job opportunity to relieve short-term cash flow issues at the expense of waiting out for the perfect job? As an example, if your household has two income-generators, you may not need as big an emergency fund.
Are you self-employed and your income is inherently unpredictable? Do you sometimes go months without an invoice? Do you own a seasonal business and earn less cash in the off-season?
Your planned length of time without income will drive the number of months of living expenses you will need in your emergency fund.
Emergency Fund Sizing Step #3 – Budget For Unplanned Expenses
Emergency funds are also designed to cover unexpected large expenses. Understanding what these expenses could be and how much they could be is tricky. These expenses were not considered when thinking about ongoing living expenses and they certainly aren’t considered by the convention income-based rule of thumb for sizing an emergency plan. Let’s look at a few examples:
- Unexpected car breakdown – cars breakdown and fixing them can be expensive. Personal Finance Cheat Sheet outlines four common costly repairs. Cost and likelihood are driven by what cars you drive and their age.
- Unexpected home maintenance – Air conditioners cease in the heat of summer (as has happened to me and almost everyone I know). The basement may flood. The roof may leak. These items can be quite costly and happen when you least expect them. A homeowner will need a bigger emergency fund than a renter.
- Major medical bill – depending on your medical insurance, what you owe in the case of a catastrophe could range from a few hundred to thousands.
- Insurance waiting period – some types of insurance have waiting periods before proceeds are distributed. For example, a disability insurance policy may require a 90 day waiting period before you get your first disability insurance check. You will need cash to cover expenses during this 90 days
Emergency Fund Sizing Step #4 – Consider the Use Debt as an Alternative
You may be able to cover short-term cash needs with debt without needing to liquidate your portfolio or holding cash. Your capacity to take on debt depends heavily on your net worth and other aspects of your financial position. One potential source of cash is a home equity line of credit. If you own a home, interest rates are sufficiently low, and you have not maximized debt leverage in your home already, you may be able to access cash relatively cheaply, and the interest owed on this debt up to $100,000 will be tax-deductible. If you have access to relatively affordable debt that can be accessed quickly, you may use this to replace or partially offset your cash emergency fund need. Of course, taking on more debt increases risk in your financial situation, so talk to your financial advisor about whether this strategy is right for you.
Pulling It All Together – The Right Size for You
So given all of this, what is the right emergency fund for you? The answer is that it depends. There are a lot of variables to consider. You do not want your emergency fund bigger than needed because there is an opportunity cost to putting that money toward other objectives like buying that new car you want or investing in other assets to try to accumulate wealth faster. You also don’t want your emergency fund to be too small because it may not accomplish the needs for you that the emergency fund was designed for when you need it.
Talk with your financial planner about these issues. Your advisor should understand your various needs and help think through these questions and translate them into a target number. Comprehensive financial planning considers all aspects of your financial situation, and as you have seen, emergency planning touches many of them including risk management, cash flow planning, debt management, investment planning, retirement planning, and estate planning. You never want to have to use your emergency fund, but you certainly want it to be there when you need it.
The information is the personal views of Josh Stillman and is not necessarily indicative of those of Capitol Securities Management. The information contained herein has been compiled from sources believed to be reliable; however, there is no guarantee of its accuracy or completeness. Any opinions expressed here are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected.