This is the third installment in our series on how individual investors can assess their financial health.
Surveys of consumer finances often conclude that American households have far too little—if any—emergency savings. In a 2011 study by the National Bureau of Economic Research (NBER), 25% of Americans surveyed indicated that they had no way to come up with $2,000 within 30 days to cover an emergency—and an additional 19% concluded that they could only do so by selling or pawning their possessions or resorting to payday lenders. The NBER study refers to such households as financially fragile. In a 2013 survey, the Federal Reserve Board found that only 48% of people were confident that they could easily access $400 in an emergency.
A commonly-cited goal for emergency savings is to have six months of living expenses available on short notice. But the 2013 Fed survey found that 64% of people aged 45-59 and 42% of people aged 60+ had less than three months of living expenses available in the event of a job loss or some other financial setback.
If you have six months of expenses covered in the form of highly liquid assets, you are probably in good shape. The reality, however, is that most households have nowhere close to this level of liquid assets.
Key Considerations in Emergency Savings
Generalizations aside, the amount of money a household actually needs in the event of an emergency will vary considerably, depending on multiple factors, such as insurance coverage, credit, and job security. Some households may also have the flexibility to cut back on non-essential expenditures, which can provide some source of relief during an emergency.
The types of insurance that you carry and your deductibles for different situations are a major consideration. If you have substantial life, disability, and health coverage, you may consider yourself safe. But your out-of-pocket costs for treatment of an illness or an emergency room visit should be a starting point for how much you need to set aside for health care contingencies.
The availability of low-cost credit determines whether you can quickly borrow at a reasonable interest rate. If you maintain an untapped line of credit on your home, for example, you don’t need as much cash on hand.
The amount you need in an emergency fund also depends on the type of work that you do. In some jobs, breaking a finger can result in substantial time off work. In others, people can work with a leg in a cast. Some jobs have far more income security than others. Federal and state employees are very rarely laid off, while independent contractors can experience huge swings in income in the course of any given year. Because losing a job is one of the more likely income disruptors for most households, it is also worth accounting for how hard it would be to find a new job. The period of time between jobs depends on a number of factors, including where you live. And as people get older, the amount of time required to find a new job increases.
Where Emergency Savings Live
All of these factors also determine whether emergency savings need to be maintained in a checking or savings account or whether they might be invested in some way. There is no universally applicable rule as to how much money a household should maintain in a savings account, the most easily-accessible and lowest-risk option.
Assets invested in retirement accounts should not be considered as emergency assets. Withdrawing funds from these accounts can result in a range of penalties and additional taxes. Assets invested in a traditional brokerage account can be part of emergency savings, but keeping emergency savings in risky asset classes means that the value will fluctuate and you may end up selling at an inopportune time. The key issue in deciding where to maintain emergency assets is liquidity: how rapidly you can get the funds.
Avoiding Financial Fragility
The sobering reality is that more than half of American families could be thrown into financial turmoil in the face of an emergency room visit, a broken furnace, or a couple of weeks of unemployment. While many families may simply be unable build up an emergency fund, there are also probably quite a few that realistically can—and should—make different choices to build the financial cushion they need.
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