A recent study by the New York Fed indicates that roughly 1 in 3 people wouldn’t be able to cover a $2,000 emergency expense in the next month if it were needed. It’s an interesting household statistic that the Fed started tracking in 2015, but it doesn’t quite tell the whole story. While the Fed doesn’t ask the survey respondents who could come up with the $2,000 where they would get the money, I can tell you from experience that about half of these people would have to sell something to generate the cash (stocks, bonds, the ring Grandma left you in her will, etc.). Others might find themselves taking a withdrawal from an IRA, which could result in penalties, or taking a loan from their 401k. The sad thing is that most people know they need an emergency fund to cover the costs related to inopportune life events but either can’t or won’t set one up. Why is this?
Setting up the fund – the obstacles
One reason people fail to establish an emergency fund is because it isn’t fun or exciting. People aren’t going to discuss their emergency funds at cocktail parties, and you will never be on the cover of Fortune magazine because you established an emergency fund.
Another reason people fail to establish an emergency fund is that in today’s low-rate environment it might be difficult to stomach a relatively large amount of cash sitting in an account earning little to no interest. But, for the same reason that you don’t buy homeowner’s insurance after your house burns down, you don’t want to have to raise cash AFTER an emergency occurs. It’s generally considered a good practice to avoid making complex financial decisions during an emotional time, which is essentially the definition of an emergency situation. If you don’t have your emergency fund established in advance, you run the risk of having to decide which assets to sell at what will likely not be the best time. This would require you to analyze issues like liquidity, tax liability, and optimum-price, all during whatever chaos was thrust upon you. These are the types of decisions that are best made when your head is clear.
What qualifies as an emergency, and how much should I set aside?
At this point, if you are still reading, we are just going to assume you are on board with this whole Emergency Fund thing and move on. From here it’s probably a good idea to know what is meant by “emergency”? A financial emergency is any unforeseen financial burden such as getting laid off, a sudden medical expense, a flat tire or car insurance deductible, or the need to buy the newest Galaxy Note or iPhone (just kidding about that last one, but you get the point).
Now that you know WHY you need an emergency fund, how do you know how much to set aside? Let’s first take a look at what the financial planning world considers to be the golden rule. According to the Financial Planning Association, as well as the curriculum taught to Certified Financial Planners, the golden rule is that you should have enough in your emergency fund to cover 3 months of necessary expenses if you are married and 6 months of expenses if you are single. This assumes that both spouses work. If one spouse loses their job, you still have half of your income. While I’ve had numerous discussions with clients about what constitutes a “necessary expense,” let me assure you that it doesn’t include golf green fees or weekly trips to the spa, but I digress.
Once you’ve calculated your monthly expenses it’s also important to qualify the stability of your income. For example, a tenured college professor has more income stability than a self-employed business owner. It would be a shame to give up an entrepreneurial endeavor simply because you ran out of money due to an insufficient emergency fund. Many people feel that they have adequate job security. The problem with this is that since the end of the ‘90s, we’ve had a tech bubble, a housing bubble, a freeze in the credit markets and an energy bubble, all contributing to longer periods of unemployment for large swaths of the population.
How long are we talking here? Well, despite unemployment being in the low 5% range for the past four months, according to the Bureau of Labor and Statistics, the data also indicates that the average length of unemployment has been between 26 and 31 weeks (6–7.5 months) with the median between 9 to 12 weeks (2.5–3 months). So what does this mean for you? It means that if you were to save 3 months of living expenses and lose your job, then you’d better hope that you fall into the median and not the average. So, based on the stability of your income, you may need more than what the Financial Planning Association suggests as the golden rule.
While any amount of money set aside for emergencies is better than nothing, the most current data from the BLS indicates that your target for emergency savings should be more in the range of covering 6-9 months of expenses. Now logic tells us that this is probably enough, but I’m a firm believer in Murphy’s Law, which states that anything bad that can happen, will happen, and at the most inopportune time. So, I typically recommend 9 months, just to be safe.
Lastly, how should emergency funds be invested? There are a few things to consider: safety of principal, liquidity, and return. They should be considered in that order. I will never be able to stress this enough – for an emergency fund, consider keeping it as cash, or at the most, in a Certificate of Deposit (CD). I highly recommend against seeking yield on emergency fund dollars by investing in things like ultra-short bond funds, high-yield money market funds, municipal resets, or auction rate preferred securities. Remember that it wasn’t long ago that many retail investors discovered the reach for yield could have dire consequences. In 2007 and 2008, folks were trying to eke out a few extra dollars by investing in the aforementioned investments only to be met with heartache. People that really needed their cash found that the credit markets froze up, the auctions failed, ultra-short duration bond funds, like the Reserve High Yield, broke the buck (when the NAV of a money market fund falls below $1), and even money market mutual funds were unable to pay out their investors. All of these instances were resolved over time, but if you were some of the unlucky few who actually needed cash in the midst of the Great Recession, then it’s likely you were out of luck. With these things in mind, consider letting your cash be cash, or at least a short-duration FDIC-insured CD.
Think about how an emergency fund could function in your life. Relying on credit cards in a true emergency may be a short-term fix, but cannot sustain you over a longer period of time without potential financial damage (you can see how your debts are affecting your credit by getting your credit scores). Optimism can be a very good thing, but so can having a safety net for more challenging times.