exploring the emergency fund

It's not always easy to get a bead on exactly what "normal people" understand about their finances.  I tend to frequent public blogs and forums (places like Reddit and Quora) where people discuss personal finance best practices and strategies, as well as industry "insider" newsletters and trainings about investor psychology and behaviors.  My top level impression is that most people have a pretty decent, general idea of "personal finance": save some money, invest for the long term, try not to overpay for advice.

One very basic part of every financial plan, and one that tends to be reduced to a simplistic rule, is the "emergency fund".  It could also be called "cash on hand" or "liquid funds" or something similar, but the idea is the same: this is a stash of money set aside from the monthly budget (it shouldn't be spent down and replenished in a "normal" period) and that it mostly held in a very low risk way (checking or savings account at the bank is very typical); the purpose of this money is to cover extraordinary expenses or demands on the budget to prevent serious disruptions to regular bills, lifestyle, and use of credit.  It is impossible to know the future with certainty and to plan for ever possible eventuality, but it is possible to plan for a series of reasonably likely demands on the household budget (as suggested in the picture above).  So that explains in general terms what the emergency fund is, but leads to the more practical questions around where does this rank among goals, how much is necessary , and how to hold the funds.

the emergency fund is a priority

Every person and every household have different specific needs and challenges, but everyone engaged in the process of financial planning is going to share in some measure this goal of having cash set aside for budget shocks, and that goal is going to be very near the top of their list of priorities (or should be).  "Cash flow" may not sound sexy, but once the flow of cash through a budget is pinched, everything else financial becomes very difficult to manage.  For that reason, in my planning and investment advisory work with clients, we focus on addressing this goal early and revisiting it often as life changes impact the answer to the how much question.  And speaking of...

the "rule of thumb" is a starting place - Not an end to the conversation

If you were to Google "emergency fund amount" or "how much do I need in savings for emergencies" you will likely find a number of sources pointing to a rule of thumb suggesting "three to six months of expenses".  And that is totally a reasonable place to start the conversation, provided that person's budget is pretty stable to begin with and they earn more than they spend on a regular basis.  But this is only a starting place for the conversation, because the details in peoples' lives vary so much.  Here are some considerations that could move a given person's emergency fund needs up or down significantly:

1. Number of dependents (or potential dependents!) -- larger families have relatively more exposure to unexpected costs mounting up quickly and at the same time.  For one example, a family with three kids has much more risk of surprise medical costs (one kid with a cold can quickly lead to three kids with a cold!), than does a household made up of a single person without children.
   Add to that a situation where an elderly parent or grandparent is not currently considered part of the household, but would definitely be taken in if there was a surprise need.
   
2. Number of incomes -- one possible use for the "emergency fund" is to cover lost wages during times of short term displacement from work; if a person has to deal with a month or two of being unemployed or is laid off unexpectedly, having that cash buffer can help in the gap.  Single income homes carry more risk to disruption and therefore may have a larger need in the emergency fund.
3. Insurance deductibles -- this whole discussion is around managing risk and demands on cash, and that naturally raises the topic of insurance.  In the scenario above with the three sick kids, the actual provisions of the family's health insurance become important.  What are the copay levels?  What are the individual and family deductibles and out of pocket maximums?  In my planning work, I like to consider the aggregate deductibles across a household's insurance policies as an input to their emergency fund needs; while it may not be reasonable or possible to hold in cash enough for the "worst case" scenario, it is reasonable to plan for a "bad case" scenario where multiple deductibles are in play at the same time.
4. Asset maintenance and upkeep -- the more things a household owns, the more potential cost there will be to maintain them.  For instance, a very general average for the maintenance of a home each year is ~ 1-2% of the home's value.  So a $250,000 house may require, on average, $2500+ in annual upkeep (HVAC service, new roof every 10 - 20 years, paint, plumbing, etc).  The same goes for cars, boats, RVs -- that there will be expenses is predictable, but the timing and size of those expenses may be somewhat unpredictable.
5. Income and access to credit -- a fresh out of school radiology nurse with no spouse, kids, or mortgage and who makes $75,000 per year and has minimal expenses may be better able to roll with a minor cash disruption; a $500 transmission repair could be a small bump in the budgetary road, and she may prefer to cover that expense out of earnings by just cutting back on some other expenses for a month or two.  But for a family living paycheck to paycheck, just managing to feed the kids and pay the rent, $500 could be a devastating amount.  This point can get a little fuzzy, but when considering a particular household's emergency fund needs, a person with a relatively large "discretionary spending" budget may need a relatively smaller amount set aside in a true emergency fund.

consider a tiered approach to risk

Having money in an emergency fund but not being able to access it in an emergency renders the whole exercise pointless.  With this in mind, it makes sense to consider liquidity and risk for how those funds are held.  Some people may wish to consider a "tiered" approach to holding or investing their emergency fund, particularly people with a relatively high dollar amount allocated for this purpose.

• Cash -- Cash on hand at the house, in a fireproof box or safe, is probably the most liquid option available.  The risks are "opportunity cost" (foregoing any interest or growth, like would be available at the bank or invested) and "loss / theft" if the stored cash is lost, forgotten, stolen in a robbery, burned in a house fire, etc.  For most people, keeping a small amount of cash on hand is probably sufficient.
• Checking / savings accounts at the bank -- By far the most common option for a household's emergency funds, bank accounts are considered safe (FDIC insured up to applicable limits), liquid (funds can generally be accessed daily by check, wire, ACH, or withdrawal), and partially address the "opportunity cost" issue by offering some amount of interest on balances over time.  Some people may choose to have a separate account for emergencies, or to just treat a core amount of their general account as "off limits for spending".  The biggest challenge to these accounts is likely the rather low level of interest rates in the current market.  While "loss leader" or "teaser" rates at some banks may top 1% right now, most FDIC insured accounts are going to yield far less than 1%.
  In any case, for most households, the bulk of their emergency fund should probably be held at the bank.
  
• Investment accounts -- Any investment offering a higher potential return than the interest on a checking or savings account is going to come with both less liquidity and the risk of loss.  Stocks, bonds, mutual funds, ETFs, insurance products, US Trerasuries, CDs -- the whole spectrum of possible investment options are going to have some exposure to one or both of those challenges.  And as with any investment choice, people who cannot bear any risk of loss should not expose themselves to that risk.
  With all that said, some households or people will find that they are comfortable with having a significant portion of their emergency fund in cash and at the bank, and putting the balance of that fund "at risk" in the market in a measured way.  Taxable brokerage accounts (either individual or held jointly with a spouse), ROTH style IRAs (where contributions may be accessible without tax penalty in some circumstances), "permanent life insurance" policies with loan provisions -- these may all in some way play a role in holding a subset of the assets which could be drawn upon in the event of a larger scale financial need.
  

review, revise, pivot

To wrap this up with one more piece of practical insight: The amount set aside of emergencies should be informed by each person / household's actual circumstances and exposures, and these should be reviewed periodically for fit.  When things change, the emergency provisions should also change.  In some cases, the "emergency" turns out to be the new status quo and things must be adjusted more dramatically for the long term; for example, a "short term" unemployment may turn out to be more permanent, and the emergency fund alone will not defend the existing budget and financial goals.  Or on a more positive note, people who find themselves with total wealth and income far outstripping their potential needs may choose to stage themselves out of holding a reserve account.

Ready to do some planning?

If conversations like this one pique your interest and you are ready to dive deeper into planning your own finances, email me at [email protected].  I am registered as an investment adviser in the states of Tennessee and Georgia, and may provide advice to residents of 46 other states under certain circumstances (no TX or LA at this time).  Or for a quick review of your current situation, feel free to click the following buttons:

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