Flexibility funds: beyond emergency savings

You've got your emergency savings built up. Your short-term goals are on track to be fully funded. Your cash flow easily fits into the 50/20/10 rule. You've paid off your credit cards and other high-interest debt. If you're in that place: congratulations! Also, you're probably wondering: what now?

There's a world of investments out there, and if you have access to a 401(k), HSA, and (mega-)backdoor Roths, you could sock away quite a bit in a tax-efficient savings vehicle. But before you go there, I recommend you consider a "flexibility fund".

...what's a "flexibility fund"?

Your flexibility fund is just another name I give to your normal, liquid investments, sitting in a brokerage account, not tax-advantaged in any way. It's invested in a diversified portfolio built around your risk tolerance and risk capacity, the same way as your other investments, because it's not earmarked towards a specific time horizon; like your emergency savings, you don't anticipate using it for anything in particular. Unlike your emergency savings, however, its purpose isn't to handle emergencies; rather, it's to handle opportunities that, while not necessarily vital, nonetheless require liquidity to address.

Think of it as "saving for a sunny day". Maybe you have enough in emergency savings to handle if you're laid off and need to search for a job...but not enough for a sabbatical, which you just read an article about (ahem!) and have decided could be a Good Idea At Some Point. Maybe you've found that you want to move within a couple years or so, but don't want to sell your current home, and gosh, wouldn't it be nice to have liquidity for a down payment?

We're all subject to the end-of-history illusion; we consistently underestimate how much our lives -- our environment, our likes and dislikes, our aptitudes, everything -- will change in the future. Flexibility funds are a way to address that. Do you give up some tax savings? Absolutely. Is it worth it for the flexibility? Well...ultimately, that's up to you, but I would argue that yes, it is.

How much should I put in my flexibility fund?

If the flexibility fund is by definition for an unclear goal with an uncertain timeline, how do we know how much we should put in it? While I don't have a research-backed answer for you, I can say this: a year's worth of living expenses works as a good starting place for a lot of our clients. It's large enough to handle most flexibility goals, while not being so very large as to leave too much on the table tax-wise.

Let me reiterate: this is a starting point, and it's for most of our clients. Everyone's situation is different, so you may find yourself tuning your fund up or down over time. But if you're looking for a starting point and have no idea what it might be, try a year's living expenses on for size and see how it feels.

How do I invest my flexibility fund?

In general, it's straightforward: as I mentioned above, your flexibility fund is just a portfolio, which like all portfolios should have an asset allocation that matches your risk tolerance and risk capacity. In fact, given that these assets are for wants, not needs, and the time horizon is indefinite (read: long), it's not uncommon for the flexibility fund's asset allocation to match your retirement portfolio, or even for the flexibility fund to be part of the retirement portfolio that's been optimized for tax-efficient asset location.

A word of warning: if you're used to investing in tax-advantaged accounts like 401(k)'s and IRA's, you'll need to be careful when investing in a taxable account for the first time. For example, target date retirement funds are great for a simple-if-sub-optimized all-in-one portfolio in your retirement accounts, but because they're shifting their asset allocation over time, they're liable to have capital gains distributions, which could give you a nasty surprise come tax time if you use them in a taxable account! Similarly, any time you rebalance the portfolio yourself, you could realize capital gains, so you'll need to weigh your asset allocation on one hand versus the potential tax consequence on the other.

And while it should be obvious, I want to be 100% clear, here: at some point, your flexibility fund will lose money. That's the nature of having money invested in stocks and bonds. The idea here is that this is money you don't want to lock up in your retirement accounts because you want it available for potential wants; if it's money you would otherwise keep in cash for near-term needs, it needs to be in cash. The flexibility fund has high expected long-term returns, but those returns come at the price of inevitable short-term downturns -- caveat investor!

How do I establish my flexibility fund?

If you don't already have taxable investments you can allocate as your flexibility fund, how do you start? Here are a few tools:

Consider depositing any bonuses or other "extra money" directly into your flexibility fund, if it's not going to be allocated towards anything else. Ideally, you've got your short-term cash needs taken care of via your cash flow management system; this means that income beyond your normal salary -- bonuses, employee stock sale proceeds (post-tax!), those nutty "third checks" you get twice a year if you're paid biweekly, etc. -- can get thrown directly into your flexibility fund.

Consider depositing known excess monthly income in your flexibility fund. If you're a budgeter, you likely know how much this is, and have been putting it into a sort of generic savings bucket of some sort. Now, if you find yourself using that generic savings bucket for frequent needs, I strongly recommend that you get more specific in your cash flow management; however, if you find yourself using it for only occasional wants, you might consider whether it makes more sense to put it in a flexibility fund.

If you find yourself just naturally accumulating cash in your checking account, consider using a threshold-based approach to investing in your flexibility fund, where you move money to your flexibility fund once your checking account gets beyond a certain balance. Now, your exact thresholds may vary based on your household expenses and how much they vary from month to month, but consider investing in your flexibility fund once your checking account gets above 3 months' expenses, down to a target of 1.5 months' expenses. This is less optimized than the budgeter approach above, but holding an extra month's expenses in cash won't likely have a significant impact on your long-term financial plan.

Consider -- carefully, temporarily -- reducing your retirement fund contributions. Did you hear that sound? It was a million fiduciaries crying out in terror. Yes, I just suggested that you can reduce your 401(k) contribution, if it makes sense for jump-starting your flexibility fund. This is obviously something that should not be taken on lightly -- what if you forget to reestablish your contributions once your fund is established? What if the availability of your flexibility fund causes you to spend more than you would otherwise, such that it threatens your retirement? What if you end up missing out on your employer match?

These are all extremely important considerations...and no less important is the consideration that money is meant to be spent, or given away. We nerds love making the numbers -- like our net worth -- go up, but we sometimes forget what the numbers are for. Is it really your goal to save so much for retirement that you end up sitting on a mountain of cash when you die? That's kind of suboptimal, isn't it?

(And if you're not sure whether you're on track to retire with said mountain, that's what good financial nerds with Monte Carlo projections are for!)

How do I take distributions from my flexibility fund?

Once you've identified a use for your flexibility fund and determined that the tradeoffs versus your long-term plan are worth it, it's time to take distributions!

First and foremost: in general, the further in advance you can start taking the distributions, the better, as you can smooth out the effects of taxes and of market downturns. For example, if you decide you're going to want $180K for a home down payment in 5 years, it's better for you to spread it out over 20 quarterly distributions of $9K each (see below), rather than a single distribution of $180K all at once, which might bump you into a higher capital gains tax bracket! Not to mention the fact that as soon as you've decided you're going to spend the money, the time horizon has gone from "indefinite" to "definite", and thus has moved from an investment goal to a cash goal!

("But what if I don't know exactly when I'm going to buy the home, or how much the down payment will be, or even if I'm going to end up pulling the trigger at all?" That's OK -- you don't have to be exact. Once you feel the probability will be greater than 50%, make a SWAG as to the horizon and amount, and take distributions based on that. As time goes by, your certainty will increase, and you can make course corrections as necessary. If in the example above you ended up cancelling your plans after two years, you could just reinvest the cash; an average ~$36K out of the market for an average ~1 year will not likely have a significant impact on your long-term financial plan. And if you end up finding your dream home out of the blue in year 3, you've already got $108K in cash; having to pull $72K all in one go is sub-optimal, but not a deal-breaker either!)

When the time comes to raise cash for distributions, consider doing so quarterly. You can make the actual cash transfer monthly if you like (for example, if this is for a sabbatical and you're looking to replace your monthly income), but I find that quarterly is a good balance between cost (of your time and headache!) and the aforementioned benefit of spreading out the impact of downturns and taxes. Regardless of frequency, don't forget that the cash raise is likely a taxable event; strongly consider making an estimated tax payment with part of the proceeds, while you have the cash in hand!

What if I don't manage my investments directly?

Up until this point, I've assumed that you're doing most of this yourself; however, if you've got a low-cost investment manager -- whether "robo" like Betterment or "human" like Seaborn -- you can absolutely still do this. In fact, the technical details will likely be both easier and more fully optimized! However, do be sure that you're comfortable with the asset allocation, and don't forget to pay taxes on the distributions -- most investment managers don't take that into account!

Of course, if you're like me and just love geeking out over this stuff, then you're likely excited to do this yourself! In which case, let me know what questions you have in the Facebook or LinkedIn comments below, and let's talk!

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.