Conventional Wisdom: The Emergency Fund

This is the second in a series inspired by a simple toy at CNNMoney that probably doesn’t deserve the attention. (See the first post in the series here.)

Question three in the financial health quiz is "How many months of expenses do you have in an emergency savings account?" The right answer is pretty Car in Flood crop simple:

You should keep three months’ worth of living expenses in a bank savings account or a high-yield money market fund for emergencies. If you have kids or rely on one income, make it six months.

In other words, you should have six months expenses in cash unless you are a two income household with no kids, a.k.a. DINKs.

Now I happen to think that six months is generally too much, but what makes this sort of conventional wisdom truly infuriating is its one-size-fits all nature. I am sure its defenders will say it’s just meant as a guideline or rule of thumb, but that just begs the question of why we need such a dumbed-down guideline to begin with. Can’t some things in our lives be just a little complicated?

Before going further, let me define the often undefined term of "emergency fund." This is money you have designated for use in an actual break-glass-in-case-of emergency. Events that, knock on wood, may never happen. For example, you become unemployed or your brother needs to be bailed out of jail. The random largish expenses that befall us all, the exploding water heaters and pricey dental work, are not emergency fund items. That sort of stuff will definitely happen to you. Budget for it.

It seems to me that as a first cut there are three categories that a person or household could fall into that would define the parameters of the emergency fund question. The first group are folks like me, who do not need an emergency fund at all.

Yikes! Frank, isn’t that irresponsible? Don’t you have kids?

I have kids, but I also have liquid assets. I’ve got a brokerage account with stocks and bonds worth several years of expenses. None of it is in cash, e.g. a money market fund, but I can sell something to raise money with a few mouse clicks. My broker has even thoughtfully provided me with a checkbook so I can spend money in an emergency right away.

I may be exceptional in the ratio of liquid assets to expenses (anti-social bloggers don’t spend that much) but I can’t be the only guy in America with a brokerage or mutual fund account that could be turned into ready cash at short notice. And yet I can’t remember ever seeing a personal finance writer mentioning, even in passing, that this emergency fund thing may not apply to some folks.

Of course, the key issue is one of liquidity. The second division a person could fall into in my scheme of three groups is people who are possibly just as well off as the ones in the first group, but don’t have assets they can tap so easily. In particular, I’m  thinking of people who have equity in their homes and retirement accounts like 401(k)s and IRAs.

There is a whole personal financial advice sub-genre (e.g. The Automatic Millionaire) devoted to urging people to put their savings into these not-so-liquid places exactly because it is hard to get money out. Under this philosophy what most rational people would see as an advantage, the ability to access your savings when needed, is a disadvantage. Hence the need for a separate pot of cash you can draw on.

But a person in this group has relatively easy to describe requirements for an emergency fund. It would need to be large enough to a) provide a buffer to keep from expensively tapping the illiquid assets for a smallish emergency and b) tide the person over until they can liquefy some of their assets in a big emergency. Of course, circumstances will vary from person to person, but it seems to me that a month or two of expenses would be adequate here.

It is also worth considering that for these illiquid asset owners the option to borrow as needed against assets can replace the need for an emergency fund. Many 401(k) plans allow participants to borrow from them at short notice without negative tax effects and if a person has significant equity in a house a standby HELOC might be a good choice.

The third category of people is the one that, I think, most financial advisors have in mind when they talk about emergency funds. These are the millions of people with low or negative net worth, i.e. debtors. And for them the decision on how large to make the emergency fund is much harder.

The stakes are raised because, for a person who owes money, maintaining an emergency fund can be very expensive. If you are carrying credit card debt at 20% interest, then every dollar in your emergency fund is costing you 20 cents a year. (Okay, a little less because you get some interest on that dollar, but you get my point.)

Six months of expenses in the bank sounds like a reassuring and prudent thing, but you have to ask how likely it is that that sixth month’s worth of money will be used. If the answer is that it’s pretty darn unlikely, then what you have is an over-priced insurance policy, with a premium equal to the interest on the debt you could have paid off with the money.

Of course, the obvious source of emergency cash for a debtor is more debt. That doesn’t sound very appealing, but we are talking about true emergencies, not another ill-advised trip to the mall. Unless you are a fundamentalist no-debt-ever type, you ought to concede that borrowing in an actual emergency makes sense.

But there is a potential problem with that which got some people excited earlier this year. It is possible that in a crisis, just when you need to borrow most, you won’t be able to. You lose your job and the card companies cancel your credit. This is the fear that caused Suze Orman to lose her mind in the spring. (See also my related business idea.)

I acknowledge that this is a bad year to be dismissive the worst case scenario, but you have to draw the line somewhere. To use one of those strained analogies I am so fond of, an emergency fund is like a lifeboat. How big and elaborate a lifeboat you need depends on your circumstances: how far from shore you are sailing, the climate you are sailing in, how many people might need to use it, and so on. But bigger is not always better. You have to pay for the lifeboat and carry it on the deck of your main boat.

Not only is the one-size-fits-all answer to the emergency fund question needlessly general, it’s not even appropriate for most people. Some households, the ones sailing far from shore in the icy North Atlantic, should have six months expenses salted away. But that turns out to be a fairly extreme case.  It is as if the one size for everybody was XXL rather than medium. One, two, or three months makes more sense for most people, and yes, zero is often the right answer too.

No Comments

No comments yet.

RSS feed for comments on this post. TrackBack URI

Leave a comment

WordPress Themes