Is Your Emergency Fund Actually Helping You Financially?

The financial advice that says you should have six months of expenses reserved in a savings account is taken as fact in many financial publications and websites. Unfortunately, this advice is often misplaced and misapplied, and you see it everywhere.

In reality, there are few emergencies that require you to come up with $2,000 or even $5,000 in cash on the spot. The most common emergencies are things like car repairs. Small expenditures that can often be put on a credit card and paid later when the monthly bill arrives. Alternately, most emergency funds pay for expenditures like a new roof or new windows on a home. Those fall into the category of planned spending (i.e., not an emergency). Another common reason for the emergency fund is a job change. We have found that most clients are at a point in their careers that a job transition is known well in advance, and there is typically some type of severance along with unemployment benefits. It is disruptive but it very rarely requires a material drawdown of cash reserves. In fact, most job transitions never touch their emergency funds.

What should you have instead of a giant savings account labelled EMERGENCY FUND? Adequate liquidity. Can you address unexpected expenses or changes in life circumstances? Cash investments like savings and money markets are part of that liquidity solution but bring very little value in terms of return. Investment vehicles like municipal bonds or investment grade bond funds can serve as an excellent source of liquidity and can provide additional income. Liquidity means that you can exit your investment and have access to cash in three to five business days. A small portion of your liquid assets could even be allocated to stocks, with the understanding that you would access those dollars last in an emergency, and that this approach comes with some additional risk (and potential return).

Let’s compare two hypothetical clients – Client A and Client B. Both clients keep $80,000 in their reserve funds for emergencies. They have stable jobs and no unusual circumstances that require keeping extra cash on hand. Client A maintains their $80,000 in a savings account strictly adhering to the rule of thumb. Client B adds bonds to their reserve plans, focusing on liquidity versus strictly having cash in savings.

• Client B allocates $20,000 to savings, and $60,000 to bond funds. Assume the savings earns 1% over the next thirty years and the bond funds earn 3.5%. The savings would be worth $27,000 and the bond funds would be worth $171,000 for a total of $198,000.
• Compare that to Client A whose $80,000 at 1% would be worth $108,000.
• Client B has $90,000 in additional capital, not to mention that it would have kept pace with inflation.

Of course, there are caveats with any investment strategy. Bond funds can lose value and returns vary. You should always consider your own personal risk tolerance, investment objective, tax situation, and other factors when evaluating investments. That said, holding a large amount of capital in a low return (negative after inflation) account in case you might need it once every 5, 7 or 10 years does not make sense for many families. Tiering out your reserves into a liquid portfolio of investments including cash, bonds, and other securities can provide the same liquidity benefits while potentially growing your asset base over time.

^{This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.}

^{LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.}