Why do financial planners love emergency savings funds?
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
“Why do financial planners love emergency savings funds?”
Eight reasons why financial planners love emergency savings funds as a financial safety net for you and your family:
1. Provides peace of mind and a meaningful reduction of stress.
2. Enhances financial stability for you and your family.
3. Encourages financial discipline and sets a good example for your children.
4. Reduces your reliance on debt.
5. Promotes better decision making.
6. May prevent panic-selling your investments during sharp market declines.
7. Provides the freedom and financial cushion to pursue opportunities.
8. Provides the added confidence that you may need to leave a job that you hate.
Financial planners stress the importance of emergency savings funds because they provide financial security and flexibility. An emergency fund acts as a safety net that can cover life’s unexpected expenses or loss of income without having to resort to toxic high-interest debt options like credit cards or personal loans, allowing you to weather financial hardships without going into debt. Debt is a financial hole that an emergency savings fund can help you avoid.
With the financial cushion an emergency fund provides, investors have the freedom to make investment decisions based on their long-term financial goals rather than short-term financial needs. During periods of sharp market declines and commonly during an economic downturn, investors without a financial cushion might feel compelled by fear or desperation to sell their investments and lock in losses in order to cover living expenses or unexpected costs.
“How many months of savings should be set aside in my emergency savings fund?”
Financial planners often recommend that you have three to six months' worth of living expenses in an emergency fund as a general guideline. This amount should be sufficient to cover all of your necessities such as rent or mortgage payments, groceries, utilities, transportation costs, and health care expenses.
Depending on their situation, many of our more successful clients actually aim to save up 12 to 24 months worth of emergency reserves. They set up an automatic monthly savings plan towards building up their emergency fund as a top financial planning priority. For example, if a family in Los Angeles, CA, spends $8,500 per month on their base necessities such as their rent or mortgage, property taxes, car payments, utilities, insurance, groceries etc. then 12 months worth of spending would be roughly $100,000 as their family’s emergency savings goal. If a family spends $5,000 per month on necessities, their emergency savings goal may be around $60,000.
During sharp market declines, we have found that investors are more likely to stick with their financial plan and avoid panic-selling their investments when they have met their emergency savings goal. Because market declines and economic downturns can often last 12 to 24 months, having a larger amount of emergency reserves set aside may provide you with the peace of mind needed to weather turbulent financial conditions. For example, if you were to lose your job at the beginning of an economic downturn, it may take much longer for you to find a job and replace your income than it would in a more favorable economic environment.
You might be worried about how much to save in your emergency fund. But if building up 3 to 6 months worth of monthly spending sounds daunting, remember that it's okay to start small. Even saving a little bit each month can add up over time and can help cushion the financial impact of an unexpected expense.
“Where should I keep my emergency savings fund?”
Your emergency fund should ideally be kept in a highly liquid and low-risk account. This often means a high yield savings or a money market account. The primary goal of an emergency fund isn't to generate high returns; it's to provide financial security and easy access to funds in case of an emergency.
However, you should also consider the effects of inflation and taxes. If the returns on your emergency fund are less than the rate of inflation, net of taxes, the real value of your money is actually decreasing over time. One approach to combat this is to keep enough money to cover three months' worth of expenses in a traditional high yield savings account or money market fund for immediate access, and put the rest in a higher-yielding options such as short duration tax exempt municipal bond funds or Treasury bills with the goal of keeping pace with inflation, net of taxes.
Example: For an investor with a 40% effective tax rate that is investing in a conservative municipal bond fund with a 4% yield, the after-tax return of the municipal bond fund is equivalent to a taxable bond fund or bank savings account with a yield of 6.67%. If inflation is less than 4%, then this may be a conservative investment option for staying ahead of inflation, net of taxes, and maintaining the purchasing power of your emergency fund. Unfortunately, leaving your money in a taxable, low-yielding bank savings account that earns less interest than inflation effectively guarantees that you are losing purchasing power over time.
“Why are emergency savings funds so important?”
Here are real-world examples of how an emergency fund can be a financial lifesaver for you and your family:
Job Loss: Consider the case of Emily, a single mom who lost her job due to company-wide layoffs. Thanks to her emergency fund, which she had built up to cover six months' worth of living expenses, she was able to keep up with her bills, mortgage, and take care of her son while she searched for a new job. Without her emergency fund, she would have had to consider high-interest debt options or dip into her retirement savings, which could have negatively affected her long-term financial health.
Unexpected Medical Expenses / Disability: Tom and Laura, a young couple, had saved diligently into their emergency fund despite both having stable jobs and health insurance. When Laura had a sudden health issue that required surgery and time off work for recovery, their emergency fund was able to cover out-of-pocket medical expenses and supplement their lost income. This allowed Laura to focus on recovery instead of worrying about how they would pay their bills.
Richard, a computer engineer in his 40s, had always been in good health until he was diagnosed with a serious neurological disorder. The condition made it impossible for him to continue working in his field. Thankfully, Richard had always prioritized saving for emergencies and had managed to build up an emergency fund of a year's worth of living expenses. Although he had disability insurance, there was a waiting period before benefits kicked in, and the benefits didn't fully replace his salary. Richard's emergency savings fund helped bridge the financial gap, paying for medical expenses and everyday living costs until he could adjust his lifestyle to fit his new disability income.Major Home or Car Repair: Steve, a freelancer, had an emergency fund he thought he might never use. However, one winter, a major storm caused a tree to fall on his roof, causing significant damage. Then, the very next week, his car broke down, requiring expensive repairs. Thanks to his emergency fund, Steve could pay for both the home repairs and car repairs without having to rely on credit cards.
Forced Early Retirement due to Economic Downturn: Sandra, an executive at a manufacturing company, planned to work until she was 65. However, when she was 58, a severe economic downturn led to significant layoffs at her company, and she found herself out of work. Given her age and the state of the economy, she had a hard time finding a new job and ultimately was forced to retire earlier than planned. Luckily, Sandra had a robust emergency fund in addition to her retirement savings. She was able to dip into her emergency savings to cover her living expenses, thus avoiding the need to draw down her retirement savings prematurely or face penalties for early withdrawal from retirement accounts. By the time her emergency savings were depleted, she had reached the age at which she could access her retirement savings without penalty.
Natural Disaster: The Johnson family lived in a small town in California and were fairly well-off, with steady income sources. Their life was going smoothly until a massive wildfire ravaged their community. While they were fortunate to have insurance coverage for their home, the process to assess the damage and settle the claim took several months. In the meantime, they had to find temporary housing, replace essential personal belongings, and cover unexpected expenses such as meals out and extra transportation costs. The costs quickly added up, and the family found themselves facing financial stress in addition to the emotional trauma of the fire. Thankfully, the Johnsons had prioritized having an emergency savings fund, putting away money each month until they had about six months of living expenses saved. This fund allowed them to meet their immediate needs without having to take on high-interest debt. By the time their insurance settlement came through, they were able to replenish their emergency fund and start the process of rebuilding their home and their lives.
In all these scenarios, having an emergency savings fund provided financial security in times of unexpected hardship. The peace of mind it provides can also help reduce stress during challenging situations, enabling people to make better decisions rather than feeling forced into high-cost alternatives. It's a powerful reminder of why an emergency fund is such an essential part of personal financial planning and why financial planners recommend building up your emergency reserves as a top financial priority.
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Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.