The partial government shutdown resulting in 800,000 federal workers across the county not receiving pay is a wake up call. If you are lucky enough not to be one of those employees, or one of those contractors and supporting jobs affected by the shut down, this event should raise a question in your mind about your emergency fund. Typical guidance says 3-6 months of expenses. As far as rules of thumbs that is a good choice but further analysis can refine that number and make your personal financial situation more secure.
This begs the question of how much cash you should maintain for life’s emergencies – a job loss, a big medical bill, a legal liability or a government shutdown. The answer might surprise you. As will knowing that the older you get, the more you need.
Early in adulthood, we need lower emergency cash savings. Then life gets more complex. You likely have more people who rely on you, and so the risks of job loss are greater. Maybe you work in a cyclical industry or are self-employed. This involves parking a chunk of your income in cash instruments: bank savings accounts, certificates of deposit (those without long maturities so you can access your money more easily) and Treasury bills.
Here’s a recommendation of how much cash to have:
For individuals, couples or families just starting out on their financial journeys, three months is the bare minimum. But you may need to achieve this goal through slow and deliberate savings. Start by setting aside $10 to $20 per month and living within the remainder. If you can do more, do more. Increase this as you are able, but keep it right at the edge of your comfort zone and only dip into the savings for true emergencies.
When you are in the middle of your working life – say, 35 to 60 years old – you probably are busily investing to meet goals like retirement and college payments. Meanwhile, there is the added risk of job loss, or perhaps simply job dissatisfaction. You may want to make a change before it is too late. Odds are you have a family to support. You need a bigger safety net: six to 12 months.
This safety net pays for living expenses while you are out of work, or if you change direction and quit a job. Some refer to this as F.U. savings, for when you just can't take your boss for one more day. This is more and more important as companies maintain profitability through layoffs. People are working harder to keep their jobs. Even if you never use the emergency money, having it gives you financial confidence.
When you are nearing that magical moment of maximum freedom, retirement (meaning approaching age 65), keep one to two years in safety money. This is because, with pensions sparse, your entire future retirement income is probably tied up in assets invested in unpredictable markets.
It’s easy to think that this 10-year bull market – which may or may not be ending – will continue forever. After all, last year was the first year in a decade that saw the S&P 500 dip into negative territory. But remember what happened 10 years ago? The market plunged 37% in a single year.
You need a buffer to protect you and keep your plans on track – a place to draw from not subject to market fluctuations. Otherwise, a major market drop may force you into taking a later retirement.
Ideally, once retired, you need a minimum of two years of emergency savings ready, just in case markets take a major tumble.
When people hear about building emergency savings, this is often the objection: “There is no return on these safe assets.”
True, cash returns are incredibly low these days, almost non-existent. But remember, given the uncharted waters we are in economically, it makes sense to enhance our safety nets.
You might be a huge optimist, and believe the future will be incredibly rosy. Still, you won’t know when those big temporary setbacks will occur – but they will occur. So, you should plan for them to arrive when you don't expect them.
Another objection: “Taking care of both investments to meet life goals and a large safety net requires even more of one’s income.”
The answer to this: Yes, absolutely.
Sure, it’s true that if you don’t fund your safety net, you can divert more money into a higher standard of living for today or into greater investment assets for tomorrow. But eventually, something will happen in your life, an event that calls for a sum of cash waiting patiently on the sidelines.
Your comprehensive financial plan should allow you to see the wisdom of a balanced approach that includes a sizable safety net. If it doesn’t, then it’s not comprehensive.