Getting Real About Your Emergency Fund – How Much is TOO Much?

by Darwin on March 15, 2010

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?

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1 ctreit March 15, 2010 at 10:27 am

Too much of a good thing is not a good thing. Still, having some money tugged away for an emergency is an important part of personal finances. I guess the actual amount depends on a person’s financial situation. Sometimes 6 times one’s income/expenses may make sense, at other times even 3 times may be too much. But this choice, i.e. setting aside a comfortable dollar amount for emergencies, is part of the risky choices we make in our (financial) lives. Like you say, life is about risk – and managing it according to our personal preferences.

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2 Finacial Uproar March 15, 2010 at 11:04 am

Great post.

I wrote a post along a similar theme not long ago. I said that a person should only keep one month’s expenses in a savings account, then invest the rest of the emergency fund in a diversified bond portfolio, hopefully being able to get 4-5% interest. Having a bunch of cash sitting around earning 1.4% isn’t a very smart move financially.

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3 Vishal March 15, 2010 at 11:37 am

nice post.
how much is/are your emergency savings is a subjective question because it’s one of those things that has a financial component as well as an emotional component.
I have some friends who sleep well at night knowing that have a full year’s savings sitting at ING direct.
me? am comfortable with 3 months sitting at ING.

However, I do have a question, do we know of anyone who was in this boat (with the last couple of yrs of downturn, should not be too hard to find someone) who had to dip into their savings and do we know of anyone who said, gosh, wish I had more funds saved up or hey, I’m glad I had this 1 yr’s supply saved up but I only should’ve had 3 months and the rest should have been invested in atleast an inflation beating instrument?

it would be nice to get some real life feedback.

I think this is one of those things that’s easy to solve mathematically, but with the emotional variables (if you’re married, gotta factor in your spouse’s as well), it’s not so black-n-white.

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4 Kevin Khachatryan March 15, 2010 at 2:37 pm

I think the key here is saving enough based on what kind of field you are looking for a job in.

Some sectors have been hurt more than the pharmaceutical sales industry. These reps can still expect to find a job for less than their normal income (you said 100,000 instead of 120,000). Although not the best scenario, making this much money is still good enough to sustain a great lifestyle.

However, a lot of jobs, especially in finance, are supersaturated with qualified employees that were laid off. A friend of mine said MBA’s with years of job experience had started to take undergraduate accounting positions so that they could at least earn some income. With a 33% rise in unemployment since 2007, this is the sort of industry you have to save at least enough to survive 6-8 months , or even a year.

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5 2 Cents @ Balance Junkie March 15, 2010 at 8:45 pm

I’ll be the first brave (stupid?) person to take the other side of your argument. I’m perfectly happy with a large chunk of cash sitting in GICs (Canadian version of CDs). I’m not worried about inflation yet. If it does move up, interest rates will do so as well. It’s safety first for me at the moment.

I would rather have a guaranteed 2% return than risk a 40% (or worse) haircut to my capital. It sounds like you are an advanced investor, but most people are not. I’m not saying you’re wrong to do what you’re doing. I just don’t think it’s for everyone. We’re all entitled to our own level of risk tolerance.;)

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6 LeanLifeCoach March 15, 2010 at 9:28 pm

At what point do you stop bothering with an E-fund?

At some point you have enough cash in taxable trading account that even a 90% collapse would leave you with 6 months income. So when do you no longer bother?

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Darwin Reply:

I can’t fault someone for being on the “conservative side” of the equation given how reckless most people in the states are with their finances. However, just keep in mind, CDs aren’t liquid since they carry a penalty and there are taxes due on the interest, so, before you know it, that 2% is 1.5% post tax (assumes 25% bracket) minus whatever penalty you paid for breaking it.

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2 Cents @ Balance Junkie Reply:

@Darwin, Excellent points Darwin. The tax on interest is a huge concern, especially if you have a fair amount of money involved. In Canada, a lot of people have been putting their emergency fund in a new vehicle called a TFSA. It’s tax-sheltered, but there is a $5000/year per person limit.

You’re right about liquidity too. For money I really want easy access to, I use a high interest savings account – if you can call 2% high.

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Darwin Reply:

Good question. The thing about having a sizable investment account is that during that hypothetical 90% collapse (which may very well coincide with job loss in a complete devastated depression-type scenario), that would like be the absolute worst time to have to sell common equity to pay for living expenses. While your say, 200K portfolio that turned into 20K could sustain you for a few months, you’d have nothing left invested for the rebound. Meanwhile a simple 180K/20K investment/cash allocation would have allowed those investment funds to take off again if left untouched.

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7 Wizard Prang March 16, 2010 at 9:01 am

The emergency fund is based on how much you need to _survive_, not a replacement for your salary. If that example rep needs $3000 per month for basic living expenses, then the six-month emergency fund is $18,000

If you are spending everything you make, you have bigger things to worry about, and it is time to make some hard choices.

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8 Kiber March 16, 2010 at 12:31 pm

I think the key here is saving enough based on what kind of field you are looking for a job in.

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9 tom March 17, 2010 at 10:05 am

caution – most 401k loans are required to be paid back when laid off or leaving an employer. Could subject you to a big hit with 10% penalty and taxes.

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10 Budgeting in the Fun Stuff March 17, 2010 at 2:48 pm

This made me think a bit.

I feel like risk diversification is comforting. We have a 401k and a Roth IRA invested in target date mutual funds, a Scottrade account invested in individual high dividend stocks, our smaller accounts (taxes, vacation, home and auto, etc) are with ING (1.1%), and our emergency fund is with Smarty Pig (2.01%).

Even though I see your point that leaving $30,000 laying around making less than 2% on average is wasteful, it does make me feel better to have that easily accessible.

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11 Victorino March 29, 2010 at 1:39 pm

For me, it’s not the revenue or the income that I can’t in estimating emergency fund. When it comes to emergency cash – we should think of money getting out and not getting in. In other words, we think of expenses. Hence, set emergency fund at amount I will need to spend (regular and irregular expenses).

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12 Aury (Thunderdrake) May 24, 2010 at 10:55 pm

The most important aspect of an emergency fund I think is having something that’s extremely liquid.

I don’t save in a liquid fund, because emergencies only pressure me to find more financially intelligent strategems; to work my money brains, so to speak.

Furthermore, I invest pretty heavily into gold and silver, both which are one of the most liquid assets I can think of. Completely leaving the bull market out of the equation, all I would need to do is show up to one of the many dealers I’m around (I live in a metro) and sell it. It’ll be about 5-10% below the spot price, but worth it if I really needed to in an emergency circumstance. I could do something quite similar with certain stocks as well. So my assets are congruent with my emergency funds.

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13 Annie July 15, 2010 at 10:35 pm

Great post. When I do my monthly budget, I take all the necessary expenses, and compile those into one number that I track each month, showing me my actual “monthly expenses” that I would spend if I was unemployed. For instance, that number doesn’t include child care, clothing, entertainment, restaurants, dry cleaning or gifts money. Those are luxuries to which we say goodbye in circumstances of crises.

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14 Tucker January 22, 2011 at 6:17 am

I think most people forget about credit cards… I would think, or at least hope, that a majority of people who make good money also pay off their credit balance monthly. An emergency credit card with say a $5k or even $10k limit is an excellent short term cushion. Yes, there is an abnormally high interest rate associated with it, and yes, it is absolutley no substitute for a cash account, but an excellent strategy when used in conjunction with a cash account.
Additionally, a Roth IRA allows people to remove their invested principle penalty free… It was designed for people to use it as a savings/emergency account while starting on a retirement vehicle simultaneously.

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15 Travis January 26, 2011 at 10:41 am

I think you have to go with your gut on how long you want your emergency fund to last. Some people like 6 months others a year – I personally prefer a years worth. A. 6 months to find a job and B. possible moving expenses. For me emergency fund means cash. If I want to try to earn extra money save another chunk for discretionary money. Why risk trying to make only 3 to 4% more – is that really going to help you? The time you get laid off is the time your “cool investment” will start to go down.

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