Financial Evolution: Education, Adaptation, Achievement

Advice abounds about how everyone needs to have an emergency fund and the golden rule seems to be that you should be holding 6 months’ salary (or spending, if you are able to sock away quite a bit each month).  Living paycheck to paycheck and having no liquid assets at all is a recipe for disaster.  Conversely though, financial outcomes are harmed by over-conservative investment and saving strategies.  While there’s no rational argument for having no emergency fund whatsoever, I do question the conventional wisdom.

Is 6 Months Really Necessary for Emergency Fund?

Where did 6 months come from?  The most common reason cited is that it’s assumed that following job loss, there’s a reasonable chance of success in landing a new job with a similar compensation and benefits structure within about 6 months.  While the range is huge in actual outcomes, historically, this was the presumption.  Well, society’s changed.  We’re coming out of a serious recession and it’s completely plausible that we’ll continue to see 8-10% unemployment (the ones that are counted, leaving aside the underemployed and the discouraged workers that gave up) for years to come.  Chances are, if you’re making a hefty salary and you’re laid off, you actually WON’T find a new job any time soon with the same pay and benefits.  Why?  It’s not a tight labor market.

Let’s take a pharmaceutical sales rep making $120,000 per year with salary and bonus.  I can’t think of a major pharma that has not laid off thousands of sales reps within the past 2 years.  While you may get lucky and land a job for a vacant territory or transition into medical devices or something, the reality is you’re competing with thousands of other similarly qualified candidates who are storming the same employer for the same job opening.  With free markets being what they are, why would an employer off you $120,000 total comp when they could get top talent for say, $100,000 now with the job market in shambles?

That being said, you might say, “Well, maybe my emergency fund should be even larger, more like a year – so that even with a new lower paying job, I could subsidize the lower salary out of my fund and eventually grow back into my old salary”.  Valid argument.  My personal opinion though is, rather than assuming that if you’re laid off and making assumptions on timing/comp for a future role to match your prior, you’ve got to get real and recognize that you may never grow back into that old salary on an inflation adjusted basis.  i.e. that sales rep will someday make $150,000.  But that might be 12 years from now!  While TheLadders focuses solely on 6 Figure Salaries, it’s no guarantee all those competing peers aren’t already using it.

What I’m saying is you’ve gotta adjust your expectations on lifestyle and spending to a LOWER monthly rate rather than try to cover a gap in employment with emergency savings and assume that eventually everything will be OK.  Rather than focusing on “6 months”, perhaps it’s better to focus on how long you may be out of work completely, what your burn rate is currently, how much you could save instantaneously with aggressive action if you lost your job, and then come up with a reasonable dollar amount to set aside.  This amount may be more or less than 6 months, but it will undoubtedly not be EXACTLY 6 months.

This Sounds Complex. What Factors Should I Consider?

• Let’s say you were making $10,000/month as that sales rep.  After taxes, 401k, health plan, etc., the net paycheck is more like $6,000/month.
• Using very rough ballpark numbers, if you have a $2,000 mortgage and another $2,000 in other necessary spending like food, utilities, a car payment, etc., your actual NEEDS are $4,000 per month net.  Now, in reality, you may be spending that $6,000 each month across a year on investments, travel, HD television, satellite radio and 50 other things that if needed, could be cut.  With some discipline and lifestyle changes, plan to hunker down and live off $4,000 per month during this rough patch.
• Working with a $4,000 baseline then, consider the fact that if you’re laid off, it’s highly likely that you’ll receive severance in a white collar or union job (if contractual provision exists).  If you’re not in one of those buckets, assume not then.  If you’re not receiving severance or it runs out quickly, there’s unemployment insurance.
• Let’s say you move right to the unemployment bucket and you’re going to get a check for $1300 per month post taxes (yes, for some reason we tax unemployment checks even though it’s the taxpayers paying the unemployment itself.  Circular logic it seems).
• Unemployment benefits keep getting extended as we saw this week and I don’t think any block of senators want to be responsible for shutting that down, so realistically, assume that you’ll land a new job before your benefits expire permanently.

So, your burn rate looks like the $4,000-$1,300 = $2,700 conservatively.

These Emergency Fund Targets are Unrealistic

If you had gone with that 6 months salary assumption, you would have stashed away $60,000.  Yes, that’s right, a typical middle class sales rep is expected to have $60,000 just sitting in a savings account earning 1.4% max?  This emergency fund would sustain you for 22.2 months assuming unemployment extensions continue!  While I said earlier that perhaps one shouldn’t assume they’ll land the same or higher salary right out of the gate, isn’t it a bit unreasonable to assume 2 years out of work completely?  The point here is that this generic 6 months salary guidance seems terribly conservative.  Perhaps that emergency fund should have been more like $20,000 which actually puts the coverage closer to “6 months out of work” as opposed to 6 months salary suggested.

Why is this so dangerous?

• Idle money in a savings account is actually LOSING money to inflation.  Over a lifetime, losing a few thousand dollars per year to inflation really adds up.  The opportunity cost of not having that money invested more appropriately adds up to a six-figure loss in retirement easily.
• Let’s get real.  Most Americans live up to or above their actual income.  So, how many 30 year old sales reps are going to have a home, a 401k and a savings account with $60,000 to boot just sitting idly by?  It’s probably unrealistic to expect that to be the norm, right or wrong.
• What else could you do with the $40,000 difference? Perhaps that money would be better invested in a real estate rental investment or diverting $5,000 per year over the past several years into a Roth IRA.  Perhaps you don’t have your own home and you’re renting – that $40,000 would go a long way toward a down payment.  These are long-term benefits that are highly likely to yield better results than over-insuring job loss.

Look, life is about risks. You get in your car because you view the risk of auto fatality as low, but you take that risk every day.  We buy insurance for things IN CASE they happen, not because we EXPECT them to happen tomorrow.  By having too small an emergency fund, you run the risk of foreclosure, bankruptcy, divorce and all kinds of unimaginable outcomes if things really went south.  But by insuring yourself to the hilt and not accurately assessing LIKELY scenarios, you’re costing yourself hundreds of thousands of dollars in the future when you may have permanent job loss – retirement!

Personally, I do keep excess cash on hand – usually between $10,000 and $20,000.  We have enough to get by for a couple months if I were out of work and I’ve already completed the cost-cutting exercise to show we could chop over $1,000 in monthly spending overnight if necessary.  I also have a hedged trading account that I could liquidate regardless of market conditions.  Another option people forget about is a 401k loan.  While such loans shouldn’t be taken lightly, if the alternative is loss of home or worse, it’s a good temporary solution.  But when and if I feel (if I only had that problem all the time!) there’s an abundance of cash sitting in a low-yielding savings account, I always put it to work.  Anywhere is better than 1.4%.

What are Your Thoughts?  What Rule of Thumb Do You Follow?

{ 3 comments }