“Emergency Fund: Do You Really Need One?” is a post by Adina J, a freelance writer, TimelessFinance contributor, and author of Blue collar / Red lipstick. |
 |
Wait, don’t run away! I promise this is not one of those emergency fund posts. Notice the question mark in the title? It’s there for a reason. So hear me out … pretty please?
When I first started reading PF blogs (and by that, I mean Gail Vaz Oxlade’s blog), I was immediately receptive to the idea of an “emergency fund”. I am ALL about saving for a rainy day – multiple rainy days, in fact. I swear, I’m not a pessimist; nor am I a meteorologist. But when it comes to looking into the future, all I can seem to see are clouds. I’m all about the negative “what ifs” because the positives … well, they take care of themselves, don’t they? As I got more involved with the PF “crowd”, the regularity with which the words “emergency fund” kept coming up reassured me that I was on to something. The “emergency fund” is where it’s at.
Or is it?
As I gained more familiarity with the subject matter, and began to think about it more critically, I started to question the wisdom of the “emergency fund” – and for a number of reasons. First, the poor thing is misused, or downright abused, to no end. “Emergency” means different things to different people. This fluidity in interpretation results from two things. One: the definition of “emergency” is tied to the concept of necessity. Lots of people have difficulty characterizing “necessity” in a way that doesn’t expand its meaning to the point of meaninglessness. Ergo, an emergency can easily encompass anything from a child’s life-threatening illness to a dishwasher malfunction. (No, you don’t need a dishwasher. Ditto a TV. Ditto an iPhone. I could go on.) Two: the definition of “emergency” is dependent on a person’s overall financial situation. For some people, nothing short of a work-impairing illness (not covered by sick pay or insurance), or a similarly life-changing event, might qualify as a true emergency. For someone living paycheque to paycheque, a broken taillight might qualify.
Let me state the obvious. Regardless of what your definition of “emergency” might be, you need to have savings to cover the possibility of adverse event(s) arising. If your definition is too extensive for your income to keep up – in other words, if you are already too over-extended to maintain the same level of lifestyle indefinitely – then that’s a separate problem. I’m sure that Joe probably has some ideas for you. Back to the topic at hand: if you have a car, you need to be prepared for the costs of its maintenance and eventual replacement. If you have a job, you have to have a plan to address job loss. There is, obviously, a financial cost to all of these things.
But, you will say, if I adopt this approach, my “emergency fund” would be so much greater than what the PF gods dictate is prudent. (This varies, endlessly, by the way. I think 3 to 6 months’ worth of fixed expenses is a popular threshold). And you would be right. Because an emergency fund is not enough. Or, more precisely, an emergency fund is not the ideal way to approach the problem posed by rainy days.
Think of rainy days as risk. Risk of illness, risk of unemployment, risk of car problems, risk of house problems … you name it, it’s all risk. You need to have insurance to cover off all of those foreseeable risks. For the catastrophic risks, you may be able to (and should) purchase an actual insurance policy (long-term disability, death, house fires and floods, etc.). Others will require that you self-insure. The only way to do that – you guessed it – is by saving. The amount you will need to save will depend the risks to which you are exposed. A car-less person has different exposure than someone who has a car; someone who drives a 2000 Honda has different exposure than a person driving a brand new Ferrari. In other words, the more costly your lifestyle, the more money you will need to save to ensure you can continue to live the same way without debt.
Obviously, not all risk materializes simultaneously (unless you are the world’s unluckiest person); with some exceptions, most risks have a foreseeable timeline. You must always, at a minimum, insure yourself for the unpredictable risks. As for the rest, you must anticipate the likely timing of the manifestation of the risk by ramping up savings to meet it. Your car breaking down is unpredictable; you will need a chunk of change handy at all times to cover off routine types of repair (calculated with regard to your particular model). Your car needing to eventually be replaced is a foreseeable eventuality; you will need to honestly assess the likely timeline of its demise, and start saving in anticipation as early (or as late) as your other constraints demand. And by other constraints, I mean the other, concurrent savings goals you might have.
Which brings me to my next point: savings is a fluctuating target. Some years, you will need to save more; some years, you may be able to get away with less. When savings get depleted, as risks materialize and require outlays of cash, they need to be replenished. And on the rare occasion when you’re all topped up with extra cash in hand … well, I’m sure no one requires guidance on spending discretionary income. (If you do, I would be happy to provide assistance, for a very reasonable fee.)
The main reason why the concept of “emergency fund”, as commonly understood in the PF world, falls short is that it barely begins to cover the risks to which most people are exposed. If you are very, very lucky (and with extensive actual insurance to boot), you may be able to successfully navigate life’s rainy days by relying on only a small umbrella of cash, like the much-vaunted 3-6 months’ worth of expenses. That is, only as long as rainy days are few and far between – only one or two small “emergencies” popping up at the same time – and you are diligent about patching up your umbrella after each storm. This approach is better than heading into a meteorologically unpredictable future with nary a rain-jacket, but it’s only marginally so. One bad storm, and you’ll be left with only the tatters of your financial security. It’s better to build a proper rain shelter, and while you’re at it, make sure it’s got proper insulation and drainage.
Silly metaphors aside, the answer is simple: save. As long as you can do it, don’t stop saving. You can never have too much in your savings accounts (Editor Joe’s note: yay! Thanks for justifying my ridiculous savings rate). You can, however, have too little. Don’t allow yourself to get complacent because you’ve accumulated an arbitrary amount that some blog told you is the magic number. Congratulations – now keep saving. So what if your umbrella is bigger than your neighbour’s? You’re both going to get hosed some time or another.
The way this was going made me think you were going to say “no” to EFs entirely! Yes, people’s view on what is an emergency differs, but no matter what the view, there should be come savings for it. But like you said in the end and I completely agree with, it’s a moving target. Possible catastrophes differ from year to year, so that should definitley be kept in mind as we save more or less. But like this editor dude says, we’re all going to get hosed some time or another, so you should probably save a bit for those times.
You can always make better use of your money than putting it in a so-called emergency fund. Like paying off your credit card debt, or investing it for a higher rate of return than a savings account provides. That said, it goes back to your original point, which is to simply save.
I used to be anti-emergency fund. Instead, I preferred to deploy every single penny towards investing or paying down debt. I had a HELOC set-up in case “something” came up.
The problem with this approach – I was essentially living paycheque-to-paycheque because every single penny was being whisked away immediately after pay day. I actually got in a few jams because I didn’t have access to cash.
So now I keep $1,500 in my TD account to waive the monthly fees, and I keep a few thousand in my ING savings account…which I guess you could call my emergency fund.
Let me say unequivocally that I agree with having an emergency fund. That fund should include 3 to 6 months worth of living expenses. That makes the EFund flexible based on your lifestyle. I also agree that you should continue to save vociferously.
HOWEVER, I think there can be more useful destinations for cash at some point. If I were you then, after you saved 3 to 6 months worth of living expenses, I would throw every penny at my mortgage. Sure, your mortgage doesn’t have a high rate. But think about a 4% rate:
– Your money, paid on the mortgage, will have a return of 4%
– The return is tax-free. Thus, it’s really like getting 6%+ if you’re in the highest marginal rate
– This return is permanent and riskless
Further, there’s always the “you need to invest actively in a business, real estate, dividend stocks, etc.”. It’s true that this is the smartest way to wealth (notwithstanding the fact that Canadian corporations offer fewer benefits to owners than US corporations). But not everybody will. If you don’t have consumer debt, build a full emergency fund. If you have a full emergency fund, pay off your mortgage. If you don’t have a mortgage, invest (hopefully actively, but even passively will generate a great income).
Emergency funds are a funny thing: the great idea that’s hard to place. Someone who can’t keep up with their credit card bills is better off paying their debt than saving cash. On the other hand, if you can lose $100,000 without increasing your debt you presumably have other ways to handle emergencies without using your savings account.
Another important factor in emergency savings is the old hidden expenses. People usually focus on the initial price of buying something and ignore the add-on costs, including emergencies. These seem to be proportional to cost. Houses cost a lot more than cars, so if you want one you’d better have a lot more assets for the more expensive emergencies.
The one thing that eliminates most emergencies is having an investment portfolio that can pay your bills. At that point it doesn’t matter if you can’t work for a while, or if a big expense comes up you can just work a bit to pay for it. So the best emergency planning is to get there as fast as possible. Along the way you might have a couple of occasions where you need to make withdrawals, but the potential cost of that is far smaller than the benefits of investing as much as you can as fast as you can.
We also keep cash savings for larger purchases in the next 5 years (which are too close to invest for). So that cash which we know we don’t need right away gives us something to “borrow” if we really need to without having to potentially sell investments at a loss.
I think we definitely share a similar outlook, although our family is not quite at the point of having an “investment portfolio”. This has mostly to do with the fact we are investment neophytes. Do index funds count as an investment? LOL! But that would be the goal, for sure.
We do keep short-term savings highly liquid for the same reasons you articulated.
I have expressed this opinion in the past many places and been attacked by Americans. I truly believe that there is no value for me to have a large emergency fund, a 1 or 2 month cushion is fine for my needs.
I truly can’t think of any emergency where I would require 6-8 months of liquid cash at once, especially in an environment where I can only earn 1.3% on those funds BEFORE taxes when inflation is 2% or so. Please point one out to me?
Medical emergency? I have Ontario Health Insurance and through work supplementary health insurance for things not covered by OHIP.
Disability? I have adequate short and long term disability that replaces 70% of my current earnings (this wouldn’t require 8 months of cash up front even if I wasn’t covered but still).
Job loss? My company has *very* generous severance packages for any one terminated (especially at the officer level), I have Employment Insurance, and yes, I do think people should keep 1 or 2 months worth of expenses liquid as a cushion but I don’t even see how I’d need to tap that as I’d be employed again very shortly or could go into business for myself (Chartered Accountant with great work history and references).
I have a car but it never gets used and if it broke down I’d not need it. I have adequate auto insurance in case I hit someone and was sued even though Ontario is no fault/etc.
Home repair emergency like A/C or water heater explosion? Renters Insurance for contents and as such obviously I rent. I can call my landlord and the bills are all his to deal with, not mine.
I have no kids. No emergencies there.
Insurance and a support network (professional and friends/family) trumps an 8th month emergency fund any day in my situation. If interest rates climb again so that I can get decent returns for liquid savings that beat inflation or at least match it, then I will consider the risk/rewards again and see.
Adina and I are cut from the same cloth, i thought I was alone in my thinking. Is there an emergency I am forgetting?
Which isn’t to say I don’t sock money away at a ridiculous rate (something like 40% of my gross pay) it just doesn’t find it’s way into ING anymore, it gets invested.
“I truly can’t think of any emergency where I would require 6-8 months of liquid cash at once, especially in an environment where I can only earn 1.3% on those funds BEFORE taxes when inflation is 2% or so. Please point one out to me?”
Agreed. Although for the record, you can get a much better rate (2%) at Canadian Direct Financial. I think People’s Trust is similar. I only use ING for the bonuses now.
Re: VI: I have a very large cash stockpile that’s not invested in the market. But it’s not because I think you or VI are wrong re: investing. I think the Canadian housing market is in a huge bubble. I think it’ll crash within the next 5 years. Value Indexer is very correct re: not investing money you need to spend within the next few years. If you invested money in 2008, and need to spend it in 2010, you’d have been downright screwed. Thus, I’m staying liquid because I want to pick up a house — but I simply won’t do it until prices are down 30%.
That’s another good example of where other savings can keep you protected. Our downpayment provided a pretty large cushion before we used it… large enough that we bought a car and paid the full price out of that account. That didn’t interfere with any plans but someone who is even a little irresponsible can lose a smaller emergency fund so fast that you would wonder if it helps them at all.
Adam, sounds like you’re pretty well covered. 6-8 months of savings is useful when you’re very vulnerable or have trouble planning things. But when you’re rapidly working to not rely on your income at all, you have lots of other liquid assets, and your expenses are low, it doesn’t take much cash to smooth over the smaller bumps. And investing a lot means that you have the cashflow to pay for many unusual expenses within a month which helps too.
I wonder if insurance for smaller amounts is really cheaper than having cash savings though. Depends on how often you need to make claims. Since we have a good amount of cash available for various reasons, we minimize insurance coverage to lower costs. When we tried to see if we could increase the deductible on our car insurance this year (not allowed here unfortunately), it took a few minutes to explain what we really wanted… the first few times we just got “yes, you can lower your deductible to $300 for only $100 per month!”
I have enjoyed reading everyone’s comments, and I am happy to see that my/our approach is not so “out there” as many PF bloggers would make it seem.
Oh, and Adam, I am jealous of your “low risk” lifestyle, LOL!
I’m with you on this one, Adina! I never really agreed with the concept of an “emergency fund” that you never touch. I always had cash (savings) buffers based on calculated amounts. When I was saving up for my condo, I had a pretty huge cash buffer, even though technically I was using targeted savings accounts. Money is fluid and giving it a permanent label or saying to never touch it is stupid. I trust myself with my money.
I eventually realized that when it comes down to it, my entire net worth is really my “emergency fund”. Sure, I keep a buffer in my checking account and then have some more savings at Ally (those two buffers totally about 6 months expenses), but there are also index funds in my taxable brokerage account that I could sell in a pinch (for another 3 months expenses) or withdraw contributions from my Roth IRA (another 5 months).
Exactly! That is what it comes down to, for me. Save, increase your net worth, and you won’t have to worry about emergencies. They will come, for sure, but you will be covered.
I agree with Adam – I have a low risk work lifestyle (also an accountant with excellent experience and references) but having some liquid cash on hand matters. Anything more than a month or two is probably overkill for us, but we have long term savings we could access in case of dire need.
Really like the different viewpoints everyone has on this topic!
Personally, I still like the idea of having 3 months of living expenses no matter what. Obviously, however, it’s much more important if you have tenuous employment and it’s double important if you’re self-employer. That said, I think a lot of people assume their jobs are a lot more secure than they really are. Working for somebody else, you may be one “rightsizing” decision away from the unemployment line. The thing about insurance (and that includes self-insurance where the expense is keeping liquid assets — bad events tend to correlate, so long-term stock market savings are NOT sufficient because they could be taking a dump when your employer downsizes, forcing you to sell at a loss) is that it’s always a waste — until you NEED it! I have term life insurance. For my intents and purposes, I’m literally taking $28-ish a month and lighting it on fire. But if I died young, my family will suddenly have wished I’d kept a million in insurance rather than just $530k.
While, as Echo says, you can always make better use of your money than putting it in a so-called emergency fund, I love having one.
Actually, I want a $10,000 EF.
I wrote about that here:
http://www.myownadvisor.ca/2012/05/why-we-want-a-10000-emergency-fund/
It’s actually very complicated in this active life to listen news on TV, so I only use internet for that reason, and get the hottest news.
Not sure how I stumbled onto this post, I thought it was just published today. It’s insightful, hadn’t given these more nuanced ideas much thought. I’m generally an optimist, so I’ve probably been under-self-insured for a lot of my life. However, I spent a lot of my adult life as a single guy renting an apartment, happily car-less, with a decent paying job. So, it was tough to imagine a financial disaster, and I always was a good saver.
I guess now that I’m married with a child, a reluctant car owner, and a happy home owner, there are more opportunities for emergencies. However, I still don’t leave large amounts of cash idly earning a pittance. I just have ready margin in my brokerage account, and a financial emergency is most likely to be a cashflow problem alone. I can borrow quickly and ask questions later, and if need be sell shares to get my brokerage balance back up to zero.
The title of this post “Emergency Fund: Do You Really Need One?” inspired me to generate this variation on a meme: http://www.quickmeme.com/meme/3te090/
Nice; I put your meme in next Friday’s blog party if that’s cool.
Sounds good, Joe. Good ol’ Fry.