Friday, July 10, 2015

Do I need an emergency fund?

Conventional wisdom states that individuals should have an emergency fund covering six to twelve times monthly expenses. This means that if your monthly expenses are $2000/month, you need to have $12,000 to $24,000 available in your checking/savings account. If you have a sudden one-time expense, you can use the funds from that emergency fund. After that, you can replenish it with monthly income. If you get fired from your job, you know that you will have some 6 – 12 month breathing room, before you land your next job.

I used to subscribe to the idea of the emergency fund. In my article on margin of safety in financial independence I discussed that I keep 3 – 6 months of living expenses. However, I am no longer keeping massive amounts of cash. I would say that I probably have cash covering one or two months expenses at most. Of course, there are a few reasons for that.

The first reason is the fact that I have a decent nest egg saved up over the past 8 years.


This "emergency fund" is covering close to 18 times the amount of my annual expenses. My annual dividend income is covering a little more than 2/3rds of my monthly expenses. A large portion of that income is coming from investments in taxable accounts. A growing portion of that income however is generated from tax-deferred accounts. I expect that in the future, the portion generated from tax-deferred accounts is going to increase substantially. To access the money, I need to jump through hoops. However, it is possible to access it, by knowing the rules and applying them proactively. Knowledge is power. My nest egg is invested exclusively in stocks. I have hoped to have something like 15% - 20% allocation to fixed income, which is equivalent to roughly 4 – 5 years worth of expenses. Unfortunately, fixed income valuations seem out of touch with reality for the time being. I am hopeful that fixed income will be more attractive at some point in the near future. If I were to exclusively live off my nest egg, I would definitely strive to have some allocation to fixed income. This would be CD’s or US Treasury/Agency bonds of various maturities.

The second reason why I am not worried is because I have various forms of insurance and do not have assets that could require expensive replacement. For example, I have always had health insurance since I started living on my own at the age of 18. In this case, any catastrophic payments would hopefully be paid by the insurance company. For example, I once had to have series of tetanus shots at an ER, which had a cost of $10,000. My insurance ended up covering everything, except for a couple hundred dollars.

I also do not own my residence (yet), hence I will not have to shell out ten thousand dollars for a roof or thousands of dollars to replace appliances or heating/air conditioning units. A few major expenses I would have to shell out in case of an emergency could include buying a car or covering unemployment. I would actually argue that I am in a better position than most people in North America, because technically I could live for 18 years without having a job. If I have a major illness, I am hopeful that my insurance will cover most of it. If insurance won’t cover it, and it is too expensive for my nest egg to cover it, then chances are that a typical emergency fund would not have saved me anyways.

The third reason I do not believe I need an emergency fund of 6 – 12 months expenses is because I am frugal and have several streams of income. Those include my main job, dividends and some income I generate on the side. I consistently save at least half of my paycheck, and I could also cover a little over 2/3rds of my expenses with dividends. As you can see, I have the cashflow to cover most typical emergency situations. Even if I only had my salary, a 50% savings rate could produce enough savings to cover most normal items in no time. This could be further helped by the float generated by credit cards as a temporary means of paying expenses ( to be paid off duly at the due date)

The fourth reason I do not believe I need a large emergency fund, is because I have an excellent credit score and lines of credit I can tap. For example, if I had a major car repair, I could put it on my credit card, and pay it off as soon as it is due. Depending on my credit card cycle, this expense would not have to be paid until at least a month in the future. I could also take out the cash dividends generated from my portfolio, along with savings from my job, and pay off that short-term debt in no time. That way I would earn rewards points, not have to pay any interest, and still using float from my friendly credit card company.

The fifth reason is that there is an opportunity cost to holding large amounts of cash on hand. If I had $24,000 sitting in cash, I will have an opportunity cost of roughly $740 foregone dividend income at an average yield of 3%. In other words, by keeping so much in cash that earns nothing in a checking or savings account, I am missing out on dividend income I could have earned had I put that cash in stocks.

As you can see, my nest egg, and my line of credit can provide liquidity in the event that I need cash covering 6 – 12 months worth of expenses. If I am unemployed for an year, or if I need a new car or I have sudden expenses, I will be covered. I believe the real reason for an emergency fund for most people is because most do not save anything. If you spend all your income, you will get in trouble when you have large unplanned expenses. If you live paycheck to paycheck, a large one-time unplanned expense can derail your finances. Once you have a track record of consistently living within your means and saving a large portion of your income, you can then safely go on to the next level of personal finance. The next level is called building your nest egg. This includes both taxable and tax-deferred investments such as stocks and bonds.

If I have a really huge expense, because I have a rare condition that required hundreds of thousands of dollars in spending, and which will not be covered by health insurance, I can then simply liquidate my nest egg. A nest egg is not worth saving, if I am not around to enjoy it. Same level of thinking goes for close family too. However, the typical emergency fund is not going to cover that huge expense either. This is where a nest egg can provide a much better cushion than an emergency fund. This is why everyone should strive for building a nest egg, that can cover 300 - 360 months worth of expenses, rather than an emergency fund covering a mere 6 - 12 months of expenses.

Full Disclosure: None



Relevant Articles:

Happy Financial Independence Day
My Dividend Goals for 2015 and after
Margin of Safety in Financial Independence
How to accumulate your nest egg
The World’s Best Dividend Portfolio

17 comments:

  1. A really interesting post. I currently have about £10,000 in cash as an emergency fund. I have had this for about 5 years (before that it was much lower at about £4,000). For me, that is over a year's worth of expenses.

    However, clearly once your assets and other income streams begin to throw you significant and consistent income themselves the amount you need should be able to decrease.

    For example, let's assume I make a additional £1,000 or more next year in dividend income (which is very likely). This amounts to a further month and a third of expenses covered. Maybe, therefore, in that circumstance a reduction of the emergency fund by, say, a month is a good idea. After all, you already have that year covered still through a combination of dividend income and the emergency fund but now that capital extracted from the emergency fund can be put to use as dividend/income creating assets bulking up that stream of income too.

    I had not really actually thought of it like that before. What is more, as you say, if you have a good credit rating this gives you more flexibility. My credit card could easily cover any emergency spending and give me a month to re-accumulate funds to pay for it through dividends etc.

    Thanks a lot for the thought-provoking post. Very interesting.

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    1. Thanks for stopping by DD and commenting. It is good to look at the situation from the standpoint of cashflow, and total assets. There is the opportunity cost of the cash sitting in checking account - it could be earning £300 - £400/year in dividend income. Looking at your situation, you seem to already have a portfolio that could cover at least 3 times your annual expenses, which also generates probably at least enough dividends to cover 2 months of expenses.

      Plus, if you have a If you are good at managing your money, you can try and cut this gradually down to say 6 months expenses since you can use temporary credit from cards for example, until you get your next paycheck. And if you lose your job, you can get unemployment insurance.

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  2. About 15 years ago, I established an emergency fund using 30-year iBonds at a relatively high rate of base interest. At the time, I was concerned about having the fund accommodate the effects of inflation and not discover -- at some future date -- that it would not be able to fulfill its purpose at the precise moment when it needed to. As it turns out, I was lucky to have chosen this vehicle, because not only has it appreciated, tax-deferred, significantly over time -- in a safe and steady way, and will continue to do so for the next 15 years -- but about a year later the government changed the rules and iBonds became much less attractive.

    In my case, house ownership was a factor, and future income streams were unpredictable (it was the era of the dotcom bust). But even today, with a nice nest egg built up, knowing there's still a pot of funds available for providing a bridge over disastrous events helps me sleep better at night, even though I think of that emergency fund only once a year.

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    1. Hi EvenKeel,

      Thanks for stopping by and commenting. When income is unpredictable (self-employment or during a recession), then it might make sense to have a lot of fixed income on hand. However, if you build a sufficient nest egg, that provides enough income, then this could be the ultimate "emergency fund"

      I need to research iBonds a little more, since I am starting to think about beefing up my currently non-existent fixed income allocation.

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  3. I couldn't agree with you more. My wife and I are going through the same thought process right now. We have about 10 months worth of expenses allocated to our "emergency fund" sitting in short term CD's that are set to expire every 3 to 6 months. These accounts are only earning 1% yield.

    We have been strongly considering moving these funds as they become available into stocks. We are leaving about $1,000 in earnings each year on the table by not investing in dividend stocks as opposed to keeping these funds in CDs.

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    1. The opportunity cost of these funds sitting in cash is very high. Plus, the likelihood that those will be the only funds that you need is remote. There is unemployment insurance, health insurance, cash flow from jobs and investments if a bad thing happened. This is why I am using most of the cash to build up my cash dividend income to a level where it can cover as much expenses as possible. Plus, in most cases credit cards used responsibly can provide float to address "sudden" expenses, and not have to be repaid for a little over a month. The goal is build cashflow and assets.

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  4. Interesting thoughts, DGI. I think that marriage and children have a major impact, along with all of the factors that you mentioned. My wife and I have a lot of money in cash since we are going through a change in our phase of life. Our youngest daughter just graduated from college (magna cum laude, pardon the boast), so we have been paying huge tuition and books bills for the last 7 years (we have two daughters). College really does test your cash flow capabilities.

    We are looking for ways to minimize the toll inflation has our on money. Our credit union pays 1.55% for a 12 month CD which almost covers inflation. Almost, but not quite, and it ties up the money for a year. Not very satisfying. We were actually talking about this yesterday. I was telling her that WPC pays over 6% in dividends, 4 times the amount of the 12 month CD. The "principle", in this case the underlying value of the stock, is accessible at any time. There isn't an "early withdrawal" penalty per se, but the stock could tank and we might have to cash out at an inopportune time.

    Retirement has it's own challenges. June and July expenses exceed my pension income by a significant margin. Summer property taxes are due, plus house insurance, 3 months of water and sewage, along with the normal food, utilities, internet, etc. We also had to replace the refrigerator and television and the minivan broke a brake line. And the girls occasionally need help paying their bills. My calculations show that the pension will only cover the basic bills, but not extras which also include vacations and voluntary home improvements. In other words, we are now running slightly cash flow negative against the pension. No worries, we have the short term investments to cover for the next 4 or 5 years until the dividend income exceeds the pension income.

    As always, I appreciate that your articles make me think about what I am doing. :)

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    1. Thank you for sharing your perspective Keith. I can bet it is a challenge to support 3 kids in college, particularly when you are transitioning to retirement from full-time work mode.

      I understand you have a short-fall in June and July. However, looking forward at August and September for example, would your passive cashflows from pensions, dividends and other sources manage to cover the shortfalls from the preceding two months? If the income is not covering expenses at all, then you might have to cut some costs ( or send your girls to work and pay for their expenses :-) )

      I am also wondering, whether it might make sense to save money in cash for particular purpose - say $1000 for vacation, for which you save $300/month for say 3 months or so. Obviously, I do not know your complete financial situation, so I am just throwing out uneducated guesses. Hope your cash flow normalizes, and you can just enjoy your retirement ( and maybe pick a money earning hobby)

      Best Regards,

      DGI

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    2. DGI,
      A couple of months of high (some unexpected) expenses is going to happen occasionally. I think we are still on budget for the year. Mrs. X and I will review our situation after the New Year which should give us a good read on how we are doing. We have plenty of funds for now so we can continue to reinvest our dividends. :)
      Best wishes,
      Keith

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  5. We also keep around 3 months sitting there in Cash (savings). When we first moved into our house the furnace died in the middle of winter. Luckily, we just moved some cash around and voila. After that we just saved it up. Also helps in reno's go over budget, you can sneak a bit out to cover and save back up.

    But where I really lack is that almost all my DGI are in tax deferred accounts, so that money is stuck there. I've started utilizing the Roth IRA style account more but the allure of a tax kickback from using the tax deferred account always sucks me in. That and no witholding taxes on US stocks in the account is delicious also. But yeah, I should start putting into accounts that allow me to actually pull dividends out if I had to. Sadly, being a homeowner, my money has been getting sent that direction more and more. Luckily I'm still saving, will be doing a different car plan when mine is paid off so I'm payment free forever and can divert cash there for DGI also.

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    1. Thanks for stopping by and sharing your perspective. I agree that having assets can provide you with more options. Plus, if you have income coming from variety of sources can make a tough situation easier to handle from a budgeting standpoint. If you and your spouse both earn money from your jobs, you earn dividends, and you manage to save a decent chunk of income, you can easily handle most "unexpected" expenses that come out your way.

      I agree there are pros and cons to putting money in tax-deferred accounts. While you get good tax breaks, you cannot easily withdraw money from them.

      I have not been a homeowner before, so I could probably learn a thing or two about it from you. For example, does the house break often ( meaning does it require expensive maintenance fairly frequently)? Are those expenses on an annual basis usually exceeding the annual property tax bill?

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    2. Our house was built in 1990, so things like the furnace, windows, etc had never been replaced. So we went into that knowing it would need those updates. If you get something that is finished well and already updated, you really shouldn't have any issues - baring anything unexpected. I actually haven't had anything I didn't really expect, I knew the furnace was old but figured it would hang on a year or so longer then it did. So I would say if the house is fairly new and the main items aren't too old, you shouldn't have too many issues. With that said, I have an odd eavestrough leak that might be an easy fix, but also could turn into something nasty when a contractor goes up and takes a look. Also, any kind of reno can be nutty expensive. But I would say no, I haven't had anything unexpected that exceeded the property tax bill on an annual basis.

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  6. I ditched my emergency fund about a year before going FIRE. Now, if something unexpected comes up, I put it on a 1.5% cash back credit card (I'm looking into the Citi 2.0% back) and pay it off immediately with a margin loan from Interactive Brokers at 1.65%. If I pay myself back within 11 months, I come out ahead on interest. So far it has worked every time, including when the A/C went out and I needed to pay for a replacement. That also came in handy when I had a tree fall on the house. The insurance deductible had to come from somewhere.

    Also, I am not a robot.

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    1. Unfortunately, I cannot change the comments settings on blogger to remove the re-captcha questions. One change I can make to remove the "robot question" is removing comments altogether.

      I believe Fidelity has a 2% cashback credit card. Otherwise, it is nice to see that having assets can result in more options, and flexibility to deal with unexpected expenses.

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  7. Excellent commentary as usual, on a topic that more people need to assess and align with their needs.

    On the subject of “fixed income” as a portion of retirement income, I’m reminded of what John Bogle (of Vanguard fame) once stated in an interview I watched on CNBC. For many working class folks, their Social Security check should not be overlooked as providing the fixed income portion of their retirement. Bogel went on to say, he’d suggest 100% investment in stocks throughout retirement for those collecting Social Security, forgoing bonds all together.

    Obviously, for those able to retire before reaching the qualifying age for SS, or if interest rates rise to the levels we saw 35 years ago, fixed income via Bonds and/or CDs may make more financial sense.

    The important takeaway is $1800 - $2500 a month in “fixed income” from SS is an important part of the equation dividend investors should factor in when building their retirement portfolio. Match that dollar-for-dollar from a dividend income stream, and the retiree enjoys a decent retirement income with 50% coming from the “fixed income” provided by SS.

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  8. I've found that having more than 2 months of liquid cash as an emergency fund was sort-of counterproductive. Like your fourth point having good credit can all but solidify putting some living expenses on credit for 6 months if you really needed to (don't advise this but it's an option). Also there have been many an article about using your ROTH IRA contributions as an extended emergency fund and I feel that is also true.

    Investing the excess money today makes sense if you have a fairly steady job and can reduce spending if need be.
    Rich

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  9. If your nest egg is invested in a fairly aggressive mix then it will likely never recover if you need to use it in an emergency when the market is down. I bet the real reason why you don't want to have an emergency fund is because you can't stand the thought of all that money sitting around doing nothing for you, neither could I. There is a 3rd option. I recently posted what I think is the perfect plan to structuring an emergency fund so that you can invest it and earn mid/low returns (higher than inflation) but won't be decimated in the event of a recession if you need to withdraw it: http://www.lifeintheblack.xyz/the-plan-part-2-emergency-fund/

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