In the world of personal finance no theme knocks louder than that of the coveted emergency fund. Heck, it even features in my own rhetoric on this very blog.
Yet, I’m still not convinced it is the best way to do things for long. It is, at best, a temporary fix and a better solution exists.
What is the traditional emergency fund?
This has many monikers ranging from “rainy day savings” to “cash under the mattress”. They all translate to the same ubiquitous “emergency fund”. The concept is that throughout life, shit happens. People can lose their jobs unexpectedly, fridges can blow up and random IT errors can mean your pay comes in two weeks late. By having a fat stash of cold hard cash (try saying that three times after a few whiskeys!) closeby and ready, this emergency fund will keep our bills paid and prevent us falling prey to high interest loans and extortionate debt.
Personal finance aficionados will preach holding 6-12 months worth of expenses in a high interest instant savings account. The idea behind this magic number is that if the worst emergency of job loss occurs, you’ve now got that many months to find a new source of income to pay the bills with.
Using US data from the 2008-9 financial crisis, we saw that on average it took around 8-13 months to find employment after job loss during deep recession. In times of growth and less economic turbulence, modern financial gurus tell us to budget 1 month of job searching for each $10,000 you hope to earn. Sadly UK data is lacking on this, so please excuse the dollars.
All these points join forces nicely and seem to really begin to justify the 6-12 month emergency fund. It is quite easy to see how the average punter sees this idea and immediately subscribes to it. A cash cushion helps people to sleep at night; knowing that whatever life throws their way their cash mountain is there to shield them.
There is no hard and fast rule about what those expenses should cover. Personally I think that if you lose your job you should probably cancel your Netflix plan with immediate effect, but others find this to be vital to keeping their sanity. Lets just assume that the 6 months of expenses mean you don’t really trim back on anything and continue as is because your budget is already bulletproof.
If the average UK household was told to bank 6 months of expenses this would mean amassing a stash of £12,696. Now don’t forget, under the emergency fund rules, this stash is to become your “£0 mark”. You should not spend this money on frivolity, so no fancy-pants holidays or new shoes with this. This is only to be spent when all other means of income have stopped or an actual emergency requires funding. A same-day call out for a leaky pipe fix, for example, would be a justifiable use.
For people just finding their footing in life the emergency fund is a great benchmark to aim for.
I’m not a total cynic and I can see how this can help people when they’re just starting out. Having that cash float can really ease the nerves. I recall the days of seeing my balance dwindle between £20.78 and -£107.50 depending on how many times I wanted to eat that month. Having solid money in the bank to even pay next months bills is such a dream. Knowing that even if your pay skips those bills are already all paid in full has such a calming effect.
However, this may not be the most effective approach. For some basic starting guidance, yes. I think the cash emergency fund teaches discipline and the mental rewards are definitely noticeable. But once you’ve got a solid grounding in life, I think the emergency fund concept gets stale real fast.
In the current age of rock bottom interest rates, cash is brutally eroded by inflation. Taking that £12,696 emergency fund and shoving it into an appropriate high-interest easy access account like Marcus account will be earning you 1.5% interest, or a monthly payment to you of £15.87. With inflation sitting around the 2% mark, you’ll actually need to add an additional £64.85 to this emergency fund in year one just to hold onto your initial purchasing power.
Everyone’s life is unique. Thus, a blanket emergency fund rule is redundant.
As always the rules of thumb fall flat when examined closely. When constructing an emergency fund, I think it better to take a top-down view and tackle this as an emergency plan problem; one that is tailored to your own life and circumstances.
Some people work in very high risk gig-economy or seasonal type roles with little to no support. Others live very close to the wire in terms of their income to expenditure. Others still may have illnesses and sickness to consider.
The opposite is also true. Some people work in industries that rarely falter in recession. Some people still live at home with their parents or share bills with a spouse or roommate. Others have a second or third income to bolster the household.
Furthermore are the unemployment benefits that some employers offer. Unless dismissed from your role due to negligence or crime, many employers will pay a redundancy package (even if it is just the minimum legal requirement).
This clearly demonstrates why simply shoving 6 months of expenses into an account will be ridiculous overkill for some and a ditheringly slim number for others.
The opportunity cost trade-off.
We are taught that the key reason the entire emergency fund must sit in cash is because it is there to be relied upon when times are tough, through thick and thin. What usually correlates with recession and job loss? Stock market decline.
With that said, on average what would an emergency fund of £12,969 invested into the stock market instead of held in cash do for us? Assuming an average annual growth return of a reasonable 6%, we would expect this to grow to £16,990 after 5 years, £22,737 after 10 years and a staggering £72,919 after 30 years. (Of course this would be less if you took money out for an emergency, duh!).
Now we can see the trade off. What we hold in cash acts as insurance; we accept the loss of growth for the guarantee of capital being there when we need it.
I’m not suggesting that you jump into the market and invest your cash cushion. But hear me out.
- Every month that you haven’t lost your job is a month of lost growth on that capital.
- Every month that passes that you don’t have a £10,000 emergency is a month of lost growth on that capital.
- Every month that passes without a recession is a month of lost growth on that capital… See the theme here?
Paying for insurance is all well and good, but if you’ve a steady job, a solid skill set that makes you employable and a spouse or secondary income to rely on, I see no reason to hoard up to a year of cash in case of job loss. If you lost your job, you’d either live off the second income entirely (instead of saving it) or simply make a motion to begin to sell down some of your investments to fund your costs – just as a retiree would be doing.
It seems then that a middle ground should be sought. The method I prefer to use is a minimal yet realistic cash holding combined with investment; because when the investment nest egg is big enough, even a 50% market decline would leave you with still more than your 6 month emergency fund would have been in cash.
How should I structure my emergency plan?
Again, this will be very subjective so consider the following and how it pertains to you. When constructing an emergency plan it is most important to come up with realistic emergencies and look at how you would fund those if they happened.
How safe is your job in the near future? I personally wouldn’t peg hypothetical job loss as a specific reason to amass copious cash reserves. Only do so if you know a contract is expiring, redundancy is looming or something else knowable ahead of time is happening.
Does the household have other income? If you have a spouse that would continue contributing to the bills until you got back on your feet, that is all the less reason to needlessly hoard cash!
Do you have access to a line of credit and if so, how large is it? This will shape the required size of your cash cushion. Credit is fantastic if you always pay it off in full. The beautiful thing about credit cards is that they give you time between purchase and actually needing the money in your account to pay it off. You could feasibly buy a food shop on a credit card then sell some stocks or bonds that evening and transfer the money a few days later to pay off the card before interest is ever added.
What is your savings rate? Those that are saving 50%+ of their income a month need even less cash on hand, as every time they are paid they can pay for two months worth of expenses with each paycheque.
What helps you to sleep at night? If the idea of having less than a certain number in your bank account freaks you out, don’t hold less than that number. Though be aware you’re potentially falling foul of mental accounting if this is the case.
Adding it all together.
My personal approach is to hold approximately one and a half months of expenses in cash. This sits in a joint current account that the household bills come out of. This covers me in case of a delay in pay (not that I’ve ever experienced that yet) as all the bills will tick over just fine. It also buys me a months worth of time should a non-bills related emergency crop up, like a busted freezer. Everything not required for short term goals is invested as per my asset allocation.
Trying to mitigate the countless “what ifs” in life is truly impossible. What if I lost my job AND my house burned down AND the stock market tanked AND my accounts were hacked AND three of my relatives died? Well I suppose I’d need a £250,000 emergency fund held in an offsite fireproof lock-box that only I memorised the code to. Better start working towards that before any other financial goals in my life…
Be reasonable and realistic when pondering these things and don’t let fear grip you too tightly.