Your Emergency Fund—Does Size Really Matter?
Emergency funds are as individual as their owners. Consequently, there is no one-size-fits-all. The only critical feature of an emergency fund is that it meets your needs. Most emergency funds are created to deal with job loss or illness. Others might see the role of an emergency fund through the lens of a natural disaster or a geopolitical event. Emergency funds for these events would take on a different character entirely. The focus here is on an emergency fund designed to shepherd you and your family through a temporary loss of income due to job loss, illness or some similar event that interrupts your income stream.
When deciding how large your emergency fund should be, you should consider both your financial obligations and your living expenses.
Your first consideration should be the scope of your current financial obligations. This would include mortgage/rent, any installment debt (car payments, etc.), credit card payments, utilities, insurance payments, and all other recurring monthly payment obligations.
How much are you spending each month on life’s necessities? This should include food, prescription medications, child care, and transportation costs. In short, all expenses you deem essential for day-to-day living.
Don’t Be Tempted
At this point you are probably thinking, “Okay, I add my total monthly payments to my total living expenses, then multiply that by six, and I’m good to go!”
While I will concede that this would be better than pulling an arbitrary number from thin air, I would encourage you to take the process a few steps further and develop a rational plan that optimizes your financial well-being.
For example, an emergency fund designed to sustain you and your family through six months of unemployment may be adequate for certain people, but inadequate for others. As I said, an emergency fund isn’t just a box you check off on a to-do-list. There are a few additional variables that need to be taken into account.
- A. How stable are your income streams?
- B. How easy will securing new employment be for you? For your spouse?
- C. What is your appetite for risk?
The compelling reason to take other factors into account is this: While you want an emergency fund robust enough to meet its purpose, you don’t want to have more funds than necessary tied up in a low yielding savings instrument.
Emergency funds need to be liquid, and by liquid I mean readily available as cash. This means a savings account, a money market account or at the extreme, a short term certificate of deposit. None of these pays you much in the way of interest. As a result, you want to keep the money you have in these types of accounts to a minimum.
A Radical Approach
If you and your significant other are both employed, then plan for the loss of the largest income stream, regardless of the probabilities of losing one over the other. The only safer approach is to plan for the simultaneous loss of both incomes, creating a greater savings burden. The decision is yours.
The duration of an emergency cannot be predicted with certainty, so you will need to allow common sense, good judgment and your appetite for risk to dictate your goal.
Most experts agree that emergency funds should be liquid, and while I concur, I also recognize that tying up significant amounts of capital in highly liquid savings accounts comes at a price–lost return on investment.
In my view, only the first month’s funds need to be in a highly liquid, low return account. The second month’s funds could reasonably be placed in a higher yielding, although less liquid, savings instrument. The third month’s funding could reside in yet another, even less liquid investment, that provides a yield superior to the second month return … and so on!
Month 1: Savings, money market checking
Month 2: Short-term certificates of deposit
Month 3: Equities, mutual funds, ETFs, etc.
Month 4 and beyond: Largely unrestricted (no real estate)
The rationale for structuring your emergency fund in this manner is fairly obvious. By saving the first month’s funds in highly liquid savings or money market checking, you have achieved two critical objectives: liquidity and ease of access. The second month’s savings are still relatively liquid, but offers you a slighter better rate of return. In the third month, by having your emergency funds invested in equities, mutual funds, and ETFs, you have ample lead time to convert these assets to cash (60 days) while preserving optimal rates of return. After the third month, liquidity is less of a concern and using your usual investment strategy should not represent a concern. Ample time exists to convert these assets to cash should that become necessary.
There is no logical reason to have six months (or more) of your capital tied up in low yielding savings or money market accounts. This strategy is the best approach to an emergency fund because it allows you to preserve access and maximize your return!
What about You?
How have you structured your emergency funds? What are your thoughts on this approach?