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Emergency Funds should be Replaced with an Emergency Strategy

Here is the old way of looking at Emergency Funds:

  • Keep 3 months of take home pay set aside if you are single, a renter and have a steady paycheck.
  • Keep 6 months of take home pay set aside if you are married, have kids, and have a mortgage
  • Keep 9-12 months of take home pay set aside if you are married, have kids, have a mortgage AND have variable compensations (such as anyone in sales).

The rules of thumb may work well for many investors, but in a lot of cases the Emergency Fund concept needs to be updated.

Let’s stop thinking about it as an Emergency Fund and start referring to as an Emergency Strategy.  Not all emergencies are the same so the tools and approaches must be crafted with more care. Below is a better, more holistic approach to consider. It breaks the Emergency Fund into 3 categories, each with a separate approach:

1)      Short Term Emergency Fund:

  • 1-2 months of discretionary expenses set aside in a bank account.  This is designed to cover smaller, unplanned expenses quickly and easily.

2)      Long Term Unplanned Expenses:

  • Insurance is the backbone for these expenses.  Funds and savings are used as a supplement.
  • Ensure that the HSA account is funded or could be funded up to the deductible limit in case of a health event that’s expensive to treat.
  • In case of layoff or disability, the investor should know how much they would receive from unemployment or disability insurance and their non-discretionary expenses.  That difference, if any, needs to be funded anywhere from 3-6 months depending on the investors situation.  Certain careers are harder to come by than others and may warrant more funding.
  • The amount determined should be invested in conservative investments to minimize the fluctuations associated with the volatility in the stock market.  Instead of sitting in cash earning nothing, it continues to grow and be productive.

3)      Long Term Planned Expenses:

  • Budgeting is the backbone for these expenses. The key to this will be taking stock of the investors current physical assets and determining how much and when each should be replaced.  An investor with an aging roof and old car should have more saved than someone with a new roof and new car.
  • The goal is to determine an ongoing amount that must be saved each month so that when something breaks down, the funds to replace it have already been saved.
  • The funds are invested in conservative investments to minimize the fluctuations associated with the volatility in the stock market.  Instead of sitting in cash earning nothing, it continues to grow and be productive.
  • In conjunction with the funds invested, it may be cheaper to establish a line of credit. And use the equity in the house to one’s advantage.

Too complicated?  Here is a simplified approach:

Follow the rules of thumb outlined above to find how much should be in the Emergency Fund.  Any amount over $50,000 could be invested in a specially designed conservative portfolio of low volatility stocks and/or target date maturity bond funds.  It remains readily available, but continues to grow and be a productive asset.

The “Emergency Fund” Rule of Thumb is Broken

I have a problem with how we view the “emergency fund” and I believe that there is a better way to think about emergency savings. Recently, Forbes ran an article discussing how much should be in your emergency fund – the money set aside to cover unexpected expenses (such as car repairs, home repairs, and healthcare costs) instead of putting it on a credit card.

The article basically restates the old rule of thumb:

Keep 3 months of take home pay set aside if you are single, a renter and have a steady paycheck.
Keep 6 months of take home pay set aside if you are married, have kids, and have a mortgage
Keep 9-12 months of take home pay set aside if you are married, have kids, have a mortgage AND have variable compensations (such as anyone in sales).

Below are my list of grievances:

  1. The calculation should not be based off of take home pay, rather it should be based off non-discretionary expenses (3, 6 or 9 months of non-discretionary expenses). These are the required expenses that someone must pay, such as food, electricity and the mortgage payment. If someone lost their job, chances are they would tighten their belt and do some penny pinching to stretch their savings.
  2. Keeping the entire emergency fund sitting in cash, earning nothing is a real problem. When you factor in inflation, the emergency fund actually loses value. It’s costing the investor to keep money sitting on the sidelines.
  3. Why does the money need to be sitting in a bank account at all? There are many tools and resources available to investors that could be better.
  4. Emergency Funds tend to become a hidden crutch for the investor. Instead of taking the time to plan for future and known expenses, many investors rely on their emergency fund to cover these sort of expenses. An investor shouldn’t be too surprised that their 25 year old roof will need to be replaced soon and that their 10 year old car will require more maintenance.

Here is a simple tweak that could make an investor’s Emergency Fund a little more productive:

Follow the rules of thumb outlined above to find how much should be in the Emergency Fund. Any amount over $50,000 could be invested in a specially designed conservative portfolio of low volatility stocks and/or target date maturity bond funds. It remains readily available, but continues to grow and be a productive asset.

5 Theories Why Americans Don’t Save More

The Atlantic recently published an article in which they outline five compelling theories why Americans don’t save more for the future:

  1. Americans stopped saving when their incomes stopped growing
  2. The poor and middle class went into debt to buy houses
  3. U.S. policies make it easy to not save money
  4. The U.S. is uniquely susceptible to conspicuous consumption
  5. The pressure to keep up with richer neighbors has been greatly exacerbated by rising income inequality

Link to article

It seems to me that all five theories contribute in part to the current situation. However, I disagree with the authors belief that the solution requires more government programs and involvement. Even the author contradicts himself: The lottery hurts the rate people can save and the government’s push for homeownership contributed to the housing crisis.

Recently, I have become quite interested in how our clients and prospects save and in particular the amount they keep set aside for emergencies. Don’t these government programs, such as social security, storm damage, health insurance, unemployment, mortgage forgiveness, student loan forgiveness and multitude of other programs, have an unintended consequence? Are Americans, as a whole, becoming more dependent on the generosity of others and the government? This point is not well addressed in the article.

Should I Pay Down Debt or Invest in the Market?

As individuals approach retirement they often ask themselves what they should do to maximize their income. Specifically, they may wonder if they should pay down their debts (credit cards, auto loans, or a mortgage) or should they invest more in the markets. The answer is often times more complicated than they expect.

Exploring Investments

It’s important for investors to understand what the after-tax cost of borrowing is, especially when a mortgage with interest rate is involved. It’s possible that after-tax returns can be higher than after-tax cost of debt. Borrowers who pay a low interest rate are in a better position to invest. Other factors that determine whether or not someone should invest instead of pay down debt favor the entrepreneur and people who are willing to take risks. An investor with a loan costing them 2% per year may want to keep that debt and instead invest in the market if they think they can get 5%-6%.

Managing Risk

Risk is determined by several factors such as age, income, time frame, market activity and taxes. Most experienced investors are aware that equities can be high risk assets. A leading factor that favors investing is high disposable income, which allows for higher risk tolerance. If we revisit the above example, the investor does run the risk of investing in the market in a bad year. In that case the investor still has to service the debt, but also watch their portfolio decline in value. The higher the interest rate on the loan, the more risk the investor takes that the return on the investments will not beat the interest rate.

Paying Debt & Cash Flow

Even though debt seems like a bad word, it is helpful to a credit score to have a certain amount of debt or credit history. The first priority should be saving up six months worth of monthly expenses as part of an emergency or safety net fund. Once this fund is in place, excess money can be used to pay down debt or invest. The main barometer for deciding between debt and investing is debt-to-income ratio. If the ratio is high, paying debt is usually the wiser choice. Tight cash flow is a red flag that budget cuts will be needed.

 
With low interest rates like we’ve seen, now is a good time to review your situation.