Last Updated: September 8, 2009
It has long seemed like trivial advice. Set three to six months of money aside in an emergency fund. Well, that advice — given the effects of the recession and the fact that nearly one in 10 workers is now unemployed — is no longer something you can ignore, say financial planners.
"Unfortunately the recent recession has caused many people to reevaluate their emergency savings accounts," said FPA member, John P. Daly, CFP®, president of Daly Investment Management. "There are a lot of people out there who were not properly prepared for the tough economic times we have seen." Recent surveys have shown the following:
- Six in 10 Americans surveyed by HSBC Bank USA said they could last financially for 90 days or less without a job, while 38% said their nest egg wouldn't make it for four weeks. Nearly four in 10 of those surveyed (39%) reported being able to live on their savings for three to six months if unemployed. And, 51% of respondents with a household income of less than $50,000 could only live on savings for less than one month.
- If they were to be laid off, more than a third (34%) of those participating in a recent Monster.com survey said their "rainy day" fund would last a week or less. And only 20% of respondents indicated they could live on funds in their nest egg for six months.
According to Daly, having an emergency savings fund is critical for the following reasons: First, it provides liquid cash to cover living expenses in case an emergency occurs (i.e. job loss). Second, it allows you to keep your investments working for you while you get things back in order.
"A lot of people look to their investment or retirement accounts as a source of replacement income in the event of an emergency," Daly said. "It might be true that sufficient funds are available in those accounts but taking money from those sources could drastically affect your investment returns and goals."
For example, Daly said you might be forced to pay penalties for taking money out of a retirement account early. The other risk is selling your securities at inopportune times, like early March 2009 for example. "If an investor would have done that, they would have missed the 50 percent-plus rally we've had since then; which is something that is not easily duplicated," Daly said.
How Much Money to Put in Your Emergency Fund
Typically, the rule of thumb is to have three to six months of living expenses in emergency savings. "The variation between the three to six months would depend on your personal situation," Daly said. "For example, if there is only one source of income, you probably need to have six months of income in reserve. If you have two sources of income, three months of income for living expenses might be sufficient in an emergency fund."
FPA member, Michael Anderson, JD, MS, CFP®, of True North Advisors, LLC recommends that couples and individuals whose sources are what would traditionally be more 'secure' should set aside six months of expenses in their emergency fund. "For example, if you have a husband who is a fireman and a wife who is a school teacher, I would consider their incomes more recession-proof than others," he said.
But if you have income that might be viewed as volatile, Anderson recommends setting aside 12 months of expenses. "A good example of this would be if the husband works in financial services and the wife works at a car dealership or other retail," he said.
Meanwhile, other planners say the amount you need depends on many factors. "The old three to six month savings rule doesn't really work in this economy, if it ever worked," said FPA member, Ginita Wall, CPA, CFP®, of Plan for Wealth. "The true amount you need in savings is the funds you'd need if you lost your job, through layoff or illness, until you could get back to work again. So if you become disabled and have disability insurance that kicks in six months, you need six months of living expenses in emergency funds. But if you lost your job and it took you a year to find another one, you need a year's worth of living expenses in emergency funds, minus the unemployment insurance you'd receive. Now, if you are in a recession-proof job and have disability insurance that begins immediately, then your need for emergency funds is very low. Not many people fit that category these days, unfortunately."
Anderson said other factors need to be considered when deciding how much to put aside. "When making a decision about an emergency fund you need to take into account your marketability," he said. "Are you very experienced? Well-educated? In-demand profession? Willing to relocate? Willing to accept less than current pay?"
In addition, Anderson noted that you need to be careful to distinguish necessary expenses vs. income when deciding how much to put aside in an emergency fund. "Expenses are just that — living expenses; not Starbucks, not eating out, not Coach purses, not golf, not even retirement or other savings — it's getting by until you can add to income," Anderson said.
Where to Invest Your Emergency Fund
"I almost always recommend that my clients have at least six months in emergency savings and that those funds are in safe, liquid, cash or cash equivalent investments," Daly said. "For clients who lean more to the conservative side, I use short-term certifiicate of deposits (CDs) (those that mature in three-, six- and nine-months) in addition to the emergency fund."
As with Daly, Anderson said you need to be cautious how you invest your emergency fund. "Keep the funds liquid and fairly short-term," he suggests. "I probably wouldn't go any more risky than an intermediate bond fund when talking emergency reserve."
Other Items to Consider
Building an emergency fund is easier said than done. So how do you boost your savings? "It's easy," said Wall. "Pretend you just lost your job. Cut your spending to a nub, and hoard as much of your earnings as you can. It's a pay me now or pay me later kind of situation — the money you save today will get you through in lean times. That's why squirrels store nuts for the winter."
Besides an emergency fund, Anderson recommends creating what he calls a natural disaster 'emergency fund.' "Living in Florida, made me cognizant of that," said Anderson. "I am not talking a militia cement compound here and barrels of gas, but I always say have some cash on hand, enough food and water put aside to live for a couple of weeks, stock up on any medications, first aid kit, a way to cook, flashlights, radio, and extra blankets. Seriously, you would be surprised how few people have a basic emergency kit put together."
A financial planner from the Financial Planning Association® can help you save for your emergency fund. Find a planner.
