Questioning a financial rule of thumb
The idea that you should have a cash reserve equal to three to six months of your living expenses would almost certainly make any “Ten Commandments” list for personal finance.
It might also be one of the least obeyed commandments, as suggested in a recent post by my colleague Ellen Rinaldi. I wholeheartedly agree with Ellen’s emphasis on having a cash reserve—savings stashed in a bank account or money market fund—before getting too focused on investing.
But today’s weak economic environment has me wondering whether the “three to six months” rule of thumb is adequate. As of April 2009, the Labor Department estimated that 3.7 million Americans had been unemployed for more than six months—up from 1.4 million a year earlier.
The median duration of unemployment also rose, though far less dramatically, from 9.3 weeks in April 2008 to 12.5 weeks in April 2009 (seasonally adjusted). Even so, that means half of all people unemployed this spring had been out of work for three months or more.
Yes, some of them would have been eligible for unemployment insurance, but those benefits are likely to cover only part of a typical household’s expenses. And unemployment benefits eventually run out. I suspect that few recipients of a layoff notice feel they’ve got too much money banked for a rainy day.
So, should your emergency reserves be able to last more than six months? As with most investment or personal-finance maxims, the answer is: “It depends.”
Among the factors to consider:
- How flexible is your household budget? Some of us may have enough discretionary items in our budget to be able to dial down our spending if need be. Others have little or no leeway.
- How safe are your sources of income, whether from employment, retirement benefits, or investment income? Of the estimated 141 million people who were employed in April, it’s a safe bet that many weren’t sure whether their jobs were truly secure.
- What other resources could you tap in an emergency? Some folks plan to dip into retirement savings or draw on a home equity line of credit to keep the wolf from the door. But those are risky steps, not to be taken lightly.
The overall rise in the savings rate among households (as reported recently by the Commerce Department) suggests that a lot of us are getting serious about creating or increasing our emergency reserves. In the long run, that’s probably a good thing, because it’ll increase financial flexibility for individuals and families. It’s a glint of silver lining in the dark clouds overhanging the economy.
Notes:
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An excellent article on maintaining enough in an emergency account. My wife and I have funds in both money market accounts and bond funds to cover those expenses. When she had to replace a car of almost ten years old, we relied on those funds. Now we will start replenish those in about two days once the restrictions are lifted. Keep up the good work.
It is a good practice when looking at any suggestion to insist on looking at a rich set of alternative strategies at the same time. Otherwise, the conversation is unavoidably biased.
Here no alternatives are discussed and cash is treated as something very special. Let’s whip out the old spread sheets and find those years where “cash reserves” were smarter than “short term bond” reserves. One will find very few years of under performance, and for those years the difference will not be very meaningful. Also, there is almost no loss of liquidity in holding a short term bond fund. I fear that a disservice is done when investors are encouraged to hold more in a money market account than is needed for purely transactional purposes.
I’d say eight months is a good amount to hold for the emergency funds. You surely would not regret it but you might sorely regret not having enough savings. good luck!
This is very good advice. Currently, I have 9 months of savings divided between a money market account and a traditional savings account. We have had two rounds of layoffs at my employer. I have been lucky to survive, but knowing that I have an emergency fund lets me sleep at night.
The only things I would disagree with is the implication that if you can “dial down” your household budget, you can affort to save less. It was my experience from a previous layoff that unexpected expenses come up when I was least prepared. So, having at least 6 months of emergency reserves is a very good idea regardless of how “flexible” your household budget may be.
To evaluate whether 3-6 month’s of expenses should be saved, why not use the same criteria and today’s economic numbers to calculate a new range? Or was the old range a guess by someone and cannot be empirically recalculated? Seems to be like an ablebodied person could agument his income by working at any available job for any pay. Thus, the 50% of unenployed persons who have collected unemployment benefits from the government for at least 6 months is not a secure parameter to use. Does the government expect them to starve to death after the benefits run out?
If so, we should start to see a significant change in the stats. Perhaps tracking the rise in the death rate for the U.S. would give a better parameter for what really happens when. If the # of homeless persons starts to spike up, we might then understand how long we need to have reserves. My number is 4.5 months with planning to immediately reduce living expenses while calculating how long one’s savings will last. Not paying income tax will help. Refinancing your home is another. Why not start a Starving Family program with membership rules concerning earnings and asset disclosures. Get gifts from all the wealthy people who contribute to charities regularly.