Emergency Savings 201

Everyone knows that you should have 3-6 months of basic living expenses in emergency savings. (Right? Well, if you didn't, now you do.) But -- where should you keep the money? When should you use it? Where does it fit in your overall portfolio? Can you invest it? Does everyone really need that much in emergency savings, or are there exceptions?

All good questions. Welcome to emergency savings 201.

What's an "emergency"?

First, what exactly is "emergency savings" for? What constitutes an emergency? The idea is that if something comes along that greatly impacts your quality of life, you can use emergency savings to handle it without going into debt. For anything less (my cell phone screen is cracked! my wardrobe is out of date!), you can save up and make the purchase when you have the funds.

For most of my clients, therefore, we categorize an emergency as one of the following:

• Medical emergency - because "if you haven't got your health, you haven't got anything"

• Home emergency - because you need a place to live

• Auto emergency - because (in many places) you need a car to get to work

• Job loss - because you need income to pay for stuff

Now, most of the above are covered by insurance of some kind, and thus you really only need to keep the deductible in cash (or maybe the max out-of-pocket). The gorilla, though, is job loss...hence the recommendation to keep 3-6 months of basic living expenses in emergency savings. If you think you'd need more time to find your next job, then consider increasing that amount! If you're a dual-income household that's unlikely to see both spouses lose their jobs simultaneously, you might consider lowering it...but I've found that anything less than 2 months' living expenses starts to make clients uncomfortable about their ability to handle other emergencies. Ultimately, of course, the choice is yours.

"Emergency savings" v. "cash buffer"

Now, there's "emergency savings", but then there's just having a small "cash buffer", something to handle the little hiccups (or flat-out mistakes) that inevitably crop up in our daily lives. I mean, it might be exciting to have exactly enough in your checking account to pay this month's bills...but in my experience, that sort of excitement gets old quickly.

Instead of living on the edge, I recommend implementing a cash buffer in the form of a minimum amount that you always keep in checking, say one month's expenses. That way you're not scrambling to raise cash every time you have a small "oops", nor are you having to check your balance every day in order to avoid an overdraft!

And yes, you could technically treat that buffer as part of the 3-6 months of living expenses that your emergency savings is supposed to cover. I hereby give you permission. Before you do that, though, imagine yourself in the position of losing your job and searching for another one. How stressed out will you be, given what you have in checking and savings? Might it be worthwhile to ignore the cash buffer when calculating your emergency savings goal? It's up to you.

The priority of emergency savings

You could fund emergency savings...or you could pay off your debt, or save for the down payment on a house, or sock money into your 401(k). How do you choose?

Simply put, I recommend highly prioritizing emergency savings. When climbing the financial ladder, it generally makes sense to focus on the backstops that keep you from falling first, and then get to climbing. If you're looking for something concrete, I have very specific recommendations on priorities in my writeup on the Seaborn Personal Finance Ladder. (And yes, the "starter emergency savings" in rung 6 is equivalent to the "cash buffer" I mention above.)

Now, that doesn't mean you have to ignore everything else! Your income allocation plan should have a focus -- such as building your emergency savings -- but it also makes sense to establish minimum funding levels for your other financial goals...and to raise those funding levels every 6-12 months!

Fitting emergency savings into your asset allocation

So, how does this bucket of cash fit in with an asset allocation designed to fit your risk tolerance and risk capacity? Does it count towards your bond allocation, or what?

This is actually a trick question. Your asset allocation is for your long-term investments -- and because an emergency could happen at any time, these savings are actually a short-term goal. If you need the money in the short term, then by definition your risk capacity is minimal! So I recommend thinking of your emergency savings (and any other short-term savings) as being in an entirely different bucket than your long-term investments, and ignoring savings entirely when it comes to looking at your long-term investment asset allocation.

As a side note, this is a handy way of answering the question, "how much of my investments should be in cash?" By keeping your short-term and emergency savings in cash, you're free to keep your long-term investments entirely in riskier assets, like stocks and bonds.

Define "cash"

Now when I say "cash", of course I don't mean physical bills. I mean "cash equivalents", assets that are extremely stable in value. There are several accounts out there that fit the bill; which one should we use here?

One easy option is your brick-and-mortar bank's savings account. Advantage: convenience and simplicity, not to mention instantaneous transfers to and from your checking account. (And assuming your bank is FDIC or NCUA insured, it's definitely stable!) Disadvantage: as of this writing, interest rates for brick-and-mortar banks and credit unions are near zero -- 0.01% isn't uncommon. If we're talking about saving up for your next iPhone, that's not a huge deal. If we're talking $30K, well, now we're starting to leave money on the table.

One step up from that is an online savings account, at an institution like Ally Bank. Still fairly convenient, simple, and stable, but now we're looking at interest rates ten to twenty times that of brick-and-mortars. This is generally the "goldilocks" option I recommend to clients.

Some folks ask about using CD's to eke out even higher interest rates. They're backed by FDIC/NCUA insurance, the same as savings accounts, right? The problem is that CD's are designed to not be touched for a certain period of time, and emergency savings might need to be touched tomorrow!

But sure, you could create a ladder of CD's such that one is maturing every 3 months, allowing you to somewhat balance flexibility against higher rates. The question is simply: is it worth it? As an example, right now Ally savings accounts are at 1.8%, and their five(!)-year CD's are at 2.3%. If we're talking about the aforementioned $30K, that's a difference of about twelve bucks a month. Speaking personally, I'd rather spend my time elsewhere!

On playing with fire

"But what if I have a lot of investable assets? Do I still need emergency savings?" Well...that's not actually a bad question.

For example, consider a retiree. "Job loss" is no longer an issue, and the other potential emergencies (ideally) would only put a small dent in their overall portfolio. Said retiree might really only need the "cash buffer" we talked about earlier; any emergencies could be covered by a distribution from retirement funds, rather than keeping around tens of thousands in cash.

But even if you're not retired, this idea of covering emergencies with investments could apply. You could invest your emergency savings in a relatively conservative stock/bond mix, but overfund it such that even if a downturn happens at the worst possible moment, you'd still have the funds necessary to handle an emergency. For example, let's say you've constructed a conservative portfolio that you're confident would only lose 20% in a massive bear market. You might invest your emergency savings in said portfolio, but instead of $30K, you might put in ($30K/(100%-20%)=) $37,500.

Tread very, very carefully here. Sure, this works in theory...but do you really want to test that theory? As I write these words, we're experiencing the longest bull market in US history. It's tempting to be lulled into complacency, because it's awfully hard to even remember what 2008 was like. Sure, you could earn an extra few percent over an online savings account. But before you pull the trigger: imagine what losing your job in a downturn will feel like, run the numbers on how much more you think you'll make if you invest your emergency savings, and make sure you (and your spouse!) are comfortable with the tradeoff.

To Roth or not to Roth?

You may find yourself in a position where you could either contribute to your emergency savings, or you could contribute to a Roth IRA. To that I say: porque no los dos? Assuming you've had the Roth for five years, you can pull out your contributions at any time, tax- and penalty-free. So why not tax shelter the funds, while you have the opportunity?

Now, assuming you don't want to play with fire, you still need to safeguard the dollars earmarked for emergencies, which means investing them in money market funds. And money market funds are slightly riskier than FDIC-insured bank accounts, so be aware of that!

Of course, the whole reason to put money into a Roth IRA is to save money on taxes -- and the taxes on cash equivalents' relatively low interest rates are commensurately tiny. So why bother, in this case? Answer: while that money is in cash now, that doesn't mean it will be forever. For example, once you retire, your emergency savings needs will likely decrease per above, in which case you can then invest the cash sitting in your Roth. Ultimately, once the money is in the Roth, you can always move it around or pull it out if necessary -- but every year that goes by that you don't contribute to a Roth is an opportunity lost forever!

On getting fancy

As you can see, there are sometimes interesting discussions to be had around emergency savings. At the end of the day, though, remember that this is your emergency savings, and complexity is the enemy of reliability. (Also remember the Dunning-Kruger effect and the engineer syllogism!) It's pretty simple to set up and fund an online savings account, at which point you can then focus on your optimal path to wealth.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.