Wednesday, February 19, 2014

Emergency Fund

This is part 4 of 14 of my series on the 14 ways I am changing my financial life in 2014.

The ever-elusive emergency fund. At least it has been elusive for me. Each time I have built it up, I have ended up using it on something other than an emergency, forgetting each time to immediately re-build it. One time I used it to start a business. Another time I used it as a down payment on a house. All of my "indiscretions" directed the money toward a good financial cause, but I have to be honest and hold myself accountable: I never actually used it for an emergency, and I always failed to make my number priority building it back up again.

As one of my major changes for 2014, I am committing to only use my emergency fund for an emergency, although I am sure hoping I don't have one. So, hopefully I don't use my emergency fund for anything in 2014, although if I do, it will only be for an emergency. It will sit there, even if I start a business, buy a house, or do something else else that requires money. So how much is in my emergency fund and where is it saved? That's what I'll talk about for the rest of this post.

First I tried to think about my 'worst-case-scenario' emergency. It didn't take long to realize that losing my income would create the most devastating long-term financial challenge for me. I have insurance to financially cover just about any major catastrophe, and even disability insurance to replace my income if I was unable to work due to disability. But it doesn't replace all of it, and it takes several months after a disability before it even begins to consider making payments to me. No income is my worst-case scenario, yet there is really no realistic way to fully protect against that for life, primarily because I hope I have a lot of 'earning' years left.

Next, I went through all of my monthly outflows, or expenses, and determined which of then I would change without immediately changing my lifestyle. I would stop automatic saving/investing plans and other convenience, or non-need, items, but I kept things like music lessons and other activities for the kids. Again, I am concerned with not having to be disruptive to my lifestyle when calculating my emergency reserves. I call this amount my monthly "nut", a term commonly used in business to define the monthly amount of gross profit required to cover a company's current overhead, breaking-even without having to restructure the company.

If a drastic emergency occurred, it is likely I would make changes to my family's lifestyle and drop many of the expenses I initially kept in my monthly nut calculation. But I would rather my estimate be high, knowing that cutting them back in an emergency would only stretch out the timeline I could live on the reserves.

Next I need to figure out how many months worth of my monthly nut I should have in reserves. It really is overwhelming to contemplate, but we all need to go through the exercise to be financially responsible and accountable. Experts recommend somewhere between 3-12 months of living expenses. Since I am the sole bread-winner and my wife works at home raising our children (a non-cash producing job but, by far, more important than any of the work I do professionally), I knew we needed more than 3 months worth. This is just a simple diversification issue. If we both brought in half of the income, then if only one of us lost a job, we would at least still have the others' income until the job was replaced.

12 months feels like too much, at least for now, considering all the things going on in my life. When I am fully-employed I can usually earn a little more than our monthly "nut", meaning I usually have more savings I could dip into if needed, and, I would hope to be able to replenish the depleted reserves very quickly. In addition, I could likely find supplemental income opportunities (like pick up some consulting gigs) while seeking for the best full-time opportunity. So 12 months just didn't feel right. So, I settled in on 6 months. It's an easy calculation:

Monthly Nut X 6 Months = Emergency Fund

An emergency fund needs to possess three traits. First, liquidity, which means I can easily sell or transfer the money. An example of an illiquid investment would be stock in a small, privately-held company that is not likely to sell any time soon. That doesn't work for short-term emergency needs. Second, accessible, which refers to as short amount of time as possible to get the money into my checking account. And third, preservation of capital. This concept refers to the fact that this money does not need to grow much over time. It is much more important to make sure that it is in a safe place (like and FDIC insured savings account), not losing value, so that I don't take a loss if I need the money.

My 6-month emergency fund is comprised of a few different elements. First, I now have myself trained to live on last month's income. All of my income this month goes into a savings account at my online-only bank. It accumulates all month, then I transfer it into my checking account at the same bank at the beginning of the next month. Those are then the duns from which I pay all of my outflows and expenses during the next month, right out of that checking account. How is that part of my emergency fund? All of that incomes this month piles up throughout the month. In reality, it represents 1 month out of my 6 month emergency fund. It is paying future expenses, anyway. It is liquid, immediately available, and even earns a little bit of interest while it waits to be put to work the next month.

I have a separate savings account at my online-only bank called "6 months". This is where I keep most of the rest of my emergency fund. It is earning an interest rate of a little less than 1%/year right now. It just sits there and does nothing but earn interest. It is liquid and immediately accessible for an emergency.

Since I stopped using credit cards I have found travel for business a little more complicated. Now I have to use my own cash to support those expenses, and, in essence, I am in the hole until my company reimburses me. I have decided to use a small part of my emergency fund for this. Here's my logic.

My employer pays directly for flights and often hotels. I pay for all additional expenses incurred while traveling (like rental cars, meals, parking, etc.), and then I usually get reimbursed within a couple of weeks after I submit the expense report from my trip. I did not want these outflows (travel expenses) and inflows (reimbursement payments) disrupting the checking account that I drive my entire household budget through.

So, I set up a checking account with a different online-only bank and I use that account's debit card for all reimbursable expenses. I have put a small amount of my emergency fund, less than 1 month's allocation, into that account (which earns .25%/year interest) to cash flow the expenses until they are reimbursed. As a side note, I wanted to try out two online-only banks, so this worked out well for that purpose (I will be writing a review of them in a future post). The most important thing to note is that these funds are readily accessible for an emergency, and my employer is, at a maximum, only about 2-weeks out from reimbursing me for anything I've spent.

With all of this money tied up in low-interest but liquid and accessible accounts, I am a little stir-crazy. I would like to see my money have more of an opportunity to grow than is offered in low interest-rate savings and checking accounts offer (even though my online bank offers some of the best rates around). To be fair, in exchange for a low interest rate I am enjoying preservation of capital, an important element of an emergency fund. But I am willing to add a little more risk (meaning preservation of capital is not guaranteed) to part of my emergency fund in exchange for a little better potential return. I have taken 1/6th, or one month, of the emergency fund and put it into a portfolio primarily consisting of short term bonds with a very broad but small stake in the stock market.

I do not recommend this strategy for most. I have a lot of experience in the financial markets, and I know I can stomach the fluctuations. I am willing to take a small but very calculated risk to try and get a little better return. I am a finance geek and, if you want, can explain the beta of this small portfolio and the likelihood that it will or will not go down or up by certain percentages. I am very comfortable with it, so that is what I chose to do. The investment is liquid and accessible, the only risk is that it's value could drop at the very time I need it for an emergency. I've calculated the absolute worst-case scenario, and I'm comfortable with it. In terms of priority, I would consider this the very bottom of my emergency fund, meaning I will only access it if I have used all the other resources in my fund.

Many of you know I am Mormon. One of the tenets of my faith is be prepared for emergencies. As such, I have accumulated what amounts to about 1-year of food for my family. I have also stored other supplies that might be useful in case of an emergency. I consider this part of my emergency fund. If I have no income, I could likely avoid a grocery store for a while and be fine. I think it could amount to saving me as much as $500/month in expenses. If my situation is dire enough to necessitate the use of my emergency fund, then that savings could prove to be very important, helping to stretch out the effectiveness of those funds well beyond their intent. I take great comfort in knowing that.

The concept of an emergency fund is simple. However, it takes great focus and discipline to build it up and then only use it for its intended purpose. In 2014 I have committed to build, maintain, and use my emergency fund for merited emergencies only. I feel better knowing it is there. In fact, it gives me an interesting sense of freedom from the worries and concerns of immediate financial ruin being just one paycheck away. I would argue that this peace, if you will, empowers me to be better at what I do, unshackling my potential to be my best self.

If you have any thoughts about emergency funds and how you handle yours, I'd love to hear about them. Feel free to comment. Thanks for reading!