Emergency Funds: Boring But Necessary

For the last ten years, it’s been difficult to look people in the eye and keep a straight face when telling them they need a savings account for emergencies.  Seriously, interest rates have been so low, I’d usually get a quip about “why bother” or “it’d be better off under the mattress.” I get it. I really do. But that is beside the point of an emergency fund.  You need money set aside in case SHTF.  That way, you and your family will be able to get by for a while without you having to make drastic financial decisions to make ends meet.  

Thankfully, interest rates are going back up and there’s some yield to be had in a savings account.  That said, an emergency fund is not a matter of convenience. It is a must-have. The irony of the aforementioned reactions is that despite the low interest rates, I could have argued they were more important than ever in the low-interest rate environment.  Surely, you know someone that was laid off. Hurt at work. Had something unfortunate happen to their home. You name it. All while the economy continued to heal and presented folks with a difficult task to find work, even if they were physically or mentally able to.  The amount you need to have is personal, but as a minimum, having at least six months of expenses in a rainy day fund will make life (and sleeping at night) easier.

There are a variety of ways to start an emergency fund and no time like the present.  You can utilize a windfall of cash, sell off a portion of your portfolio, save a little bit over time.  Whatever works for you and your family. The path you take is not as important as the end result: having enough money for you and your family to live on until you figure something else out.

Why Should I Have An Emergency Fund?

I know, emergency funds aren’t sexy.  Especially in recent years when having cash parked in a savings account meant you were only earning 0.01% at some institutions.  I remember getting excited when rates started going back up and calling clients to let them know they should be shopping their savings account around because…gasp….some banks were offering 1% again!  Unfortunately, as hard as it is to swallow, an emergency fund is not about growth. Instead, it’s about security. Having to take a premature distribution from your IRA because money is tight, or having to borrow against your house because your partner got laid off are a few examples of things that an emergency fund could save you from.  The thing is, you won’t appreciate it until you need it. But the primary purpose of your emergency fund is to get you by for a while in case you lose your job. You’re going to be going through a lot, emotionally, and adding money stress on top of that is not something I’d wish on my worst enemy (currently the Philadelphia Parking Authority).  

Beyond the loss of income, it’s probably not hard to think of situations where having some cash on hand makes life easier.  I bet you have experienced, or know someone who has experienced, something that would have been made a lot easier because they had liquid assets.  Examples of this might be damage to your home (waiting on an insurance check?), a friend or relative that is in dire straits, unforeseen medical expenses, and the list goes on and on.  All of these have a long-term solution that could probably be worked out via payment plans or insurance reimbursement, but in the interim, the money comes out of your pocket first.

So far, I’ve only focused on bad things that could happen that an emergency fund could make better.  But, let’s not forget having money in a rainy day fund gives you power. Don’t like the way things are going at work?   Need to move out AND break up with someone? Have you found your dream home/car/boat/antique? Or. Orrrrrrrrrrrr. You have an HSA and you want to pay for your medical expenses out of pocket, leaving your HSA to grow tax-free until you retire and use the funds like a Traditional IRA after 65.  Having an appropriate emergency fund doesn’t just have to be about what could happen to you. Think of it as the opportunity to do what you want, when you want, without being burdened by not having the money for it. The ultimate flexibility to change your situation because you thought ahead and took action to build up an emergency fund.  

How Big Your Emergency Fund Should Be

The size of your emergency fund will be unique to what helps you sleep at night.  I prefer to see clients have at least six months worth of expenses (not salary!) on hand in a savings account, but some folks will prefer more, some less.  My professional opinion usually amounts to at least six months though. Six months should give you enough runway to figure something else out or figure something else out while you’re figuring something else out.  I’m partial to expenses instead of salary because, well, taxes. This is another reason why it is so important to know where your money is going and how your household cash flow works. Otherwise, you’ll be estimating what six months of expenses are like based on fuzzy numbers, and that won’t do you much good if you need to use it.  Some people are confident they’ll be able to change their lifestyles to reflect a change in income. To be conservative, I recommend you don’t shave much off your expenses to give yourself some buffer in your emergency fund estimates. You’re not going to stop living your life entirely if you lose your job, but you’ll probably cut back on some of the discretionary expenses.  

If you’re single and have no dependents, you can probably get by with just six months.  If you have mouths to feed though, you might want to think about having nine to twelve months set aside.  If your partner has an income, or if you have another source of income, your emergency fund can reflect the fact that losing one of your jobs isn’t going to bring your finances to a crashing halt.  I’d still recommend six months of expenses as a baseline though. Building an appropriate emergency fund will be far less painful than having to make drastic (maybe permanent?) changes to your financial situation because of a short-term problem.  

The other aspect to the size of your emergency fund will ultimately be a reflection of what you need to sleep at night.  Seriously. If you’re the kind of person that wants (needs!) to have a year’s worth of expenses on hand to feel comfortable, there’s nothing wrong with that!  This is your money, and having enough set aside for you to wake up every day and know “come hell or high water, my family will be ok” is perfectly fine. You can think of this as your emergency fund risk tolerance.  If you’re a little more conservative and like to plan for the “what ifs,” then your emergency fund will probably be a bit larger than someone not as concerned about having cash for more than six months, for one reason or another.  Whatever opportunity cost there is to having a larger emergency fund instead of investing it, should be more than offset by peace of mind.

How To Start Your Emergency Fund

I have worked with a lot of clients over the past few years that have started our relationship with a confession.  “I know I should be doing something with the money in my checking account, but I don’t know where to start.” This especially seems to happen with newlyishweds.  And they’re usually perplexed when I recommend building the emergency fund first. They always think I’m going to recommend investments, but fundamentally, the emergency fund makes way more sense.  Think of your finances like building a house. You start with the foundation. The emergency fund and appropriate amounts of life and disability insurance are the foundation, and you shouldn’t be moving on to building walls or statues in the garden until we have a solid foundation poured.  Only then, do we move on to more exciting features of the “home.”

But not everyone has a pile of cash that is begging to find a new purpose.  That’s ok too! If you’re just starting your emergency fund, commit to putting a certain amount of your paycheck towards your emergency fund.  It may take you some time to build up to the point where you have six months of expenses, but having the goal in mind and making regular deposits are all that matter.  When you’re building your emergency fund, think long and hard before you say you’ll put $100 a paycheck into your savings account and add your $20,000 bonus after you get it in February.  If that bonus doesn’t come through for some reason, you’re going to be a long way off from your goal. It’s not just that I don’t trust the bonus to be what we think it will be. I’m confident life will find other uses for that money in the meantime, and it will be earmarked for something else before it even has a chance to make its way to your savings account.  When you’re building your emergency fund, it is perfectly ok to start small and work your way up to progressively larger contributions. Start with an amount you can comfortably save from your paycheck, do it for three months, and then increase, rinse, and repeat. Over the course of two years, you’ll have made a tremendous amount of progress and habituated saving outside of your retirement plan.  

You could also fund your emergency fund with money from your portfolio.  This could include company stock you’ve been sitting on that’s become a larger share of your aggregate portfolio with additional vestings, dividends, growth, etc.  Selling off shares could be prudent risk management and give you the cash you need to set up your emergency fund. Be sure to discuss this strategy with your tax professional first, as you’ll want to make sure you fully evaluate the taxes associated with any sales.  Positions drift over time and may end up being a larger part of your portfolio than they should be, so concentrated positions could be a great place to look for the beginning of your emergency fund. The same holds true for portfolios that have increased in value and you’re looking to rebalance anyway.  Consider utilizing some of the proceeds from appreciated positions to kick-start your emergency fund.

Hopefully, I’ve convinced you that an emergency fund is a necessity, helped you think about how big your emergency fund should be, and given you some ideas about how to build yours.  If you’d like some help making sure your emergency fund is appropriate, and you’re wondering how it should be working on concert with the rest of your finances, feel free to get in touch.  brendan@meaningfulwealthmanagement.com.