Okay. It’s a bother to have to listen to the safety spiel on the airplane before taking off. Plug in the earphones, crank the volume, and get to something more pleasant. But in the back of your mind, you know and appreciate that the airline has thought of everything to keep you safe, just in case. The chances are incredibly small that something disastrous will happen, but it is also within the scheme of things.
Same thing is true in your financial life. It is boring to think about, but at some unexpected times for an unexpected reason, you will need cash – possibly a lot of it. How much have you set aside for one of those unlikely, but somehow inevitable life emergencies – a job loss, a big medical bill, a legal liability? The likelihood is out of our control, but the preparation is not.
You need emergency cash sitting in safe, easily accessible savings accounts or CDs. The younger you are, the less you need. Then life gets more complex. You likely have more people who rely on you, and so the risks of job loss are greater. Maybe you work in a cyclical industry or are self-employed.
How much should you set aside? It depends on age and life-stage:
Up to 35—Young Adults: If you are an individual, or in a couple or family just starting out on your financial journey, three months of your salary is the target minimum. If you have monthly expenses of $3500, then you should target $10,500 as your emergency fund. You may need to achieve this goal through slow and deliberate savings. Start by setting aside $50 to $100 per week and living within the remainder. If you can do more, do it! Increase the amount as you are able, but keep it right at the edge of your comfort zone and dip into the emergency savings only for true emergencies.
35-50—Middle Years: When you are in the middle of your working life, you are probably busily investing to meet goals such as retirement and college payments. Meanwhile, the risk of job loss, or perhaps simple job dissatisfaction increases. You may want to make a change while you still have time, and the odds are you have a family to support.
Because of the increased complexity, you need a bigger safety net: six to 12 months of your expenses should do it. This kitty pays for living expenses if you are out of work, or if you change direction and quit a job. This money is sometimes referred to as F.U. savings — for that moment when you can’t take your boss for one more day.
The idea of increasing your safety net is more important as companies maintain profitability through layoffs. People are working harder to keep their jobs. Even if you never use the emergency money, having it gives you financial confidence and peace of mind. (Think of those flotation devices tucked at the ready under your airplane seat.)
50-60—Nearing Retirement: When you are nearing that magical moment of maximum freedom, ‘retirement’ (meaning approaching age 60), keep one to two years in safety money.
With pensions sparse these days, a large portion of your future retirement income is most likely tied up in assets invested in unpredictable markets. During the past 12 years, the stock market has plunged twice. You need a buffer to protect you and keep your plans on track–a place to draw from not subject to those fluctuations.
Otherwise, a major market drop may force you into taking a later retirement.
65+–In Retirement: Ideally, once you are retired, you need a target minimum of two years of emergency savings ready, just in case markets take a major tumble. This additional cash on the sidelines is there to prevent your being forced to “sell low” to meet your living expenses.
When I talk to clients about building emergency savings, I often hear this objection: “There is just no return on these safe assets.” True, cash returns are incredibly low these days. But I point out that, given the uncharted waters we are in economically, it makes sense to enhance our safety nets.
We define financial planning as “Taking responsibility for all the things that can (and will) go wrong, for the opportunity to plan for all the things that can go right.” Markets WILL fall at some point; if you continue to draw from your portfolios they will run out far sooner than you expected.
I am a huge optimist, and I believe the future is rosy. Still, I don’t know when those big temporary setbacks will occur. So we need to plan for them to arrive when we don’t expect them. Cash is the best preparation for this issue.
Another client objection: “It takes even more of our income to both build investments to meet life goals and maintain a large safety net. To this I say: “Yes, absolutely. If you don’t fund your safety net, then you are free to divert more money into a higher standard of living for today or into greater investment assets for tomorrow. But eventually, an event will happen in life that calls for a sum of cash waiting patiently on the sidelines.”
I hope you never need the emergency exits on the airplane, but when you do… it will certainly be good to know where they are.
Jonathan K. DeYoe, AIF and CPWA, is the founder and president of DeYoe Wealth Management in Berkeley, California, and blogs at the Happiness Dividend Blog. Financial planning and investment advisory services offered through DeYoe Wealth Management, Inc., a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations to any individual. For your individual planning and investing needs, please see your investment professional.