One of the few personal finance concepts that garner near-universal praise is the emergency fund.
For many topics in personal finance, there are seemingly as many critics as there are advocates. “The stock market is too risky,” “You can't retire early because you need health insurance,” “You shouldn't travel because it's wastefully expensive.”
I don't agree with any of these perspectives, but you hear people offer them feedback.
Thankfully, few people disparage emergency funds because they should be an essential component of everyone's finances.
What is an emergency fund?
An emergency fund, also called a “rainy day fund” or “cash reserves,” is money that you have access to in case of a sudden unplanned need.
Typically, these funds are in the form of cash or cash equivalents. We'll jump into account and investment options later.
Emergency Funds Are Your First Line Of Defense Against Financial Ailments
I am not a scientist, but I recently learned about an immune system concept that illustrates the power of the emergency fund.
Lymphocytes are a type of white blood cell, and they either become T cells or B cells with different roles in your immune system. One type fights infections, and the other type remembers past infections and goes into action if you are re-infected.
Much like the lymphocytes, an emergency fund is a resource that enables flexibility. It can spring into action when a need arises, and it can “specialize” to become whatever type of support you need at the moment.
Here Are The 3 Main Reasons You Need An Emergency Fund
Life can be expensive at times. Unexpected expenses are indeed not unexpected. Events like car repair, small medical bills, or broken cell phones are likely to happen occasionally.
Recently, a popular stat has inspired many articles and tweets — 40% of Americans can't cover a $400 emergency expense.
Avoiding Unnecessary Debt
If you don't have cash available to pay for an expense like this, or if you suffer a job loss, the alternatives don't offer a positive outlook.
Credit cards often have interest rates over 20% APR, and payday loans are even worse.
A home equity line of credit (HELOC) can be lower interest, but any form of debt can compound if left unpaid.
Help Manage Investment Or Economic Volatility
Even if you have some investments, there's the volatility that cannot be predicted with certainty. That is an issue for retirees, especially since they want to avoid being forced to sell an investment after a substantial drop in market value.
Most often, people are referring to the stock market when they use the term “volatility,” but the concept applies even more broadly. If you own a rental property or a business, those investments can be affected by market volatility too.
How large of a cash reserve should you maintain if you depend on investments for your livelihood? We'll dive deeper into this below.
Safeguard Against A Job Change
Job changes are inevitable and even common. Last year, the Bureau of Labor Statistics reported that median tenure for men was 4.3 years, and median tenure for women was 4.0 years. Shifting to a new role every four years is a lot of change.
Of course, unwanted and unexpected job loss can be more of a challenge financially. But, even if you're choosing to change jobs on your own volition, it's best to be prepared for the transition.
Perhaps most importantly, having an emergency fund in place can give you the security to boldly pursue a new opportunity in your career or the confidence to leave an unhealthy workplace.
The Downside Of Emergency Funds — Opportunity Cost
Other than a lack of disposable income or self-control, I think the main reason people don't make maintaining an emergency fund a priority is that it's not exciting. And, frankly, they're right.
An emergency fund doesn't have the same upside that real estate or other investing offers.
There's no chance that your emergency fund will suddenly double in value over a few years, like a hot stock.
There's an opportunity cost involved because the money in your emergency fund is necessarily not being used for something else. But that's okay. That's the whole point.
I don't recommend comparing your emergency fund to your investments because I don't think of emergency funds as investments.
Instead, I recommend thinking of it as insurance. Insurance costs you money, but it protects you, and it makes your life less risky. Your emergency fund has the same function.
How Much Do You Need To Set Aside In Your Emergency Fund?
Well, It depends! Your emergency fund should be a reflection of your lifestyle's ability to tolerate and respond to risk.
Consider a few examples.
Single Income Or Variable Income, Larger Emergency Fund
Let's say you are a single income family, including two spouses and three kids. Your job that has to support the whole family is entirely commission-based because you are a real estate agent.
That is a situation where you might want to maintain a larger emergency fund, like six months of expenses (or even more!).
You have a lot of people and expenses to attend to, and a change in the local real estate market could drastically affect all of your income.
Dual Income Or Consistent Income, Leaner Emergency Fund
Alternatively, if you and your spouse have no kids and both have full-time, salaried jobs in unrelated industries, you may feel comfortable with a more lean, 3-month emergency fund.
It's unlikely that you would both lose your jobs at the same time, so you would probably still have half of your family's income available if one of you does have a job change.
Plus, if you don't have kids or generally have low expenses, it would be easier to “tighten the belt” and adjust your expenses down during the job transition if necessary.
You may have noticed, in the previous example, I mentioned that it matters what industry you are and your spouse works in. If you work in the same industry or related industries, this increases your risk a bit.
An external factor could affect both of your employment statuses simultaneously.
For example, if you and your spouse both teach at a public middle school, a cut in the local education budget could impact both of your jobs. So, this is worth considering.
Choose An Option That Fits Your Family's Needs
All of the variables above are important to consider, but ultimately you need to choose a savings target that is a good fit for your family. It comes down to preference and comfort.
Clearly, someone earning a ton of passive income from real estate might not need as large of an emergency fund as someone who's primary source of income is an hourly part-time job.
My wife and I both work full-time in unrelated industries, and we have no kids, but we maintain an emergency fund of a bit more than six months of expenses. That's just what it takes for us to sleep well at night.
Cash Reserves During Retirement
When you retire, you will likely need extra cash reserves in addition to your standard emergency fund, if you are planning to live off of your investments. The rationale here is that your investments themselves are volatile.
You want to avoid needing to sell too many shares to cover your expenses if the market takes an extreme dip. Having cash reserves available can allow you to live off of the cash instead of needing to sell investments right after a crash.
Traditional retirement, mini-retirement, and semi-retirement will all require different approaches for your cash reserves.
There can be wide variation in the details of people's retirement planning, so consider this advice but consult a financial advisor on what approach will be best for your specific situation.
Typically, retirees live off of a combination of investment income, Social Security benefits, and pensions (which are increasingly less common now than in decades before).
Traditional retirees will want to have vast cash reserves available so that they do not have to draw down on their investment portfolios if there is a major market volatility event.
That may sound contradictory to the previous sentence, but I am not an advocate of market timing.
I do think it is wise, though, to understand that volatility should be expected, and you can minimize realizing investment losses if you have cash available to draw from in case of emergency.
Deciding exactly what amount of cash reserves you need should primarily depend on two factors:
1) the proportion of your expenses that your investments need to cover and
2) your family's ability to adjust your lifestyle to minimize expenses if required.
Here's an example: Your investments only need to cover 10% of your retirement expenses because you have a great pension benefit. You have budgeted to travel a lot during your retirement years. Still, if there is a downturn in the stock market, you can travel less or travel to less-expensive destinations in the short-term to reduce your expenses significantly.
In this scenario, you do not need a large amount of additional cash reserves.
Take a look at the rolling returns of the stock market over different periods. For the S&P 500 index, the worst 1-year rolling return was -43%. That would be an unpleasant time to need to make a withdrawal.
The worst 20-year return was 6.4% per year. That demonstrates the value of investing in the long-term, but keeping 20 years worth of expenses on hand is not feasible for most of us.
Using this S&P 500 historical return calculator, the S&P 500's worst rolling return over three years was -35.2% (or, -11.7% per year). This is, of course, not very exciting, but it's much less upsetting than -43%.
I recommend that retirees keep three years of expenses as cash reserves, or more if they rely heavily on their investments and do not have a flexible expenditure level.
Retirees should work with a financial advisor or tax professional to determine the most efficient way to maintain this cash reserve.
A mini-retirement is quitting your job for some time to return to full-time work later.
Unless you have some kind of passive or part-time income you can count on to cover your expenses during this time, I would recommend having all of your mini-retirement expenses saved up in cash before you pull the trigger.
Plus, you should still maintain your regular emergency fund — emergencies are still possible during your mini-retirement.
You also want to be prepared in case it takes longer to find new full-time employment than you are expecting.
Cash Reserves During Semi-retirement
Semi-retirement is what I cover on my home site, Semi-Retire Plan. I have talked through the details of semi-retirement and how you can access your retirement accounts early if you want to semi-retire before you reach 59½.
The abridged description of semi-retirement is that you can work part-time for a period to bridge your full-time working years to your full-retirement years.
This can give you a lot of flexibility and help you retire sooner.
For semi-retirement, you will still need your standard emergency fund plus cash reserves, depending on how dependent you are on your investments.
The exact amount of cash reserves that you need, though, can vary based on your family's ability to adjust your expenses in the event of market volatility.
As you approach full retirement, you should consider increasing your cash reserves as you become more dependent on your investment income.
Where Should You Keep Your Emergency Fund?
For most people, especially while working and maintaining an emergency fund to cover only a few months of expenses, I recommend keeping the money in a high-interest savings account.
Even after recent interest rate decreases, banks like Ally and Barclays are offering over 2% interest on savings accounts.
You won't become wealthy on 2% interest, but it's better than earning nearly zero percent if the money was sitting in a checking account.
And, remember, your emergency fund is insurance, not an investment. The best thing about using a savings account is that the money is straightforward to access if you do have an emergency.
If you're looking for a slightly higher return on your money and you have a more substantial amount of cash reserves, you could consider laddered certificates of deposit (CDs).
With this strategy, you buy CDs of varying terms. Then when the shorter-term CDs come to an end, you can use the money if you need to. If you don't need it, you can re-invest it in a new CD, and repeat the process.
For most people, this approach is unnecessarily complicated, and a savings account will offer a return that is nearly as high.
You should not keep your cash reserves in something volatile. Remember, this money needs to be readily available if you need it unexpectedly.
With your new emergency fund plan in place, you are now prepared to deal with the small problems life will throw at you. You can sleep well, knowing you won't be going into debt tomorrow!