One of the most common pieces of advice offered by financial planners is to have an emergency fund easily accessible to provide for unexpected expenses. According to a national survey of 2,000 adults by Pew Research, 34% indicated they had an unexpected event in the past year, such as a medical problem or a home related expense, which set them back financially. Unfortunately, additional research has shown that we’re just not saving enough. A study by Bankrate.com revealed that 46% of Americans could not adequately cover three months of expenses, and only 24% have saved enough to cover six months or more. Emergency funds are there to provide a safety net and cover expenses until you are able to get your fiscal house back in order.
Though most agree these funds are necessary, there is no real consensus regarding the appropriate amount. Many factors will influence the size of your fund, including whether you have one or two incomes, earnings from other sources such as pensions or investments, access to a home equity line of credit, and your overall cost of living. It’s common to underestimate expenses or to only consider fixed expenses such as a mortgage or car payments, but families need to examine their entire budget to estimate how much they may truly need if the unexpected were to occur.
While we believe there is reason to be optimistic about the economy and financial markets going forward, many families are still wary from the financial crisis and concerned about job security. The average duration of unemployment is nearly 40 weeks and those individuals tend to live on credit to replace income, which highlights the importance of maintaining a reserve fund. Keeping a rainy day account that contains nine months to one year of expenses is a good rule of thumb for most families, but the best approach should be customized to your own personal circumstances in consultation with your advisor.
If you don’t have an emergency fund, start saving whatever you can now. While it can be challenging to find the cash flow after contributing to your 401(k) and IRAs, the best advice is to start small and make systematic contributions. Look for discretionary expenses that you can reduce, such as taking a cheaper vacation or eating out less, to support your savings.
I have worked with many clients who have expressed their frustration with the lack of “growth” in their emergency fund. As you know, short-term interest rates have been below 1% for four years and the Federal Open Market Committee has indicated it will keep its target at nearly zero for the foreseeable future. With Truepoint’s 70% stock/30% bond allocation returning over 14% last year and bonds returning over 4%, it is extremely tempting for families to invest their reserves in a strategy that may provide higher returns. We must, however, resist that temptation.
It’s easy to be a “Monday Morning Quarterback” and see that you would have done much better over the past few years owning stocks or bonds but, as we’ve consistently pointed out, it’s impossible to predict the future. Therefore, it’s important to remember the primary purpose of maintaining an emergency fund: security. To ensure no risk of principal to your funds, we recommend holding them liquid in a savings or money market account at an FDIC insured institution, so it is there when you need it.