By: Joseph Goldy, AAMS®
Living through the current pandemic has taught me to appreciate many things that I previously took for granted. Traveling on a plane, walking down busy city streets, or simply sharing a good meal at a restaurant with friends comes to mind. The global health crisis has also reaffirmed an appreciation for an emergency fund from a financial planning aspect.
What is an Emergency Fund?
The purpose is simple; if you lose an income source unexpectedly, where will that shortfall be made up from, and for how long? It is not there to earn a high return; the peace of mind you receive, knowing you have your expenses covered, is its return.
Having the ability to make up for an income deficiency quickly and efficiently alleviates stress and provides stability when needed most, without incurring additional debt or liquidating investments at an inopportune time.
How Much Should You Save for Your Emergency Fund?
How much of an emergency fund one should have will depend on an individual's needs and how many people depend on a specific income source. Generally, the more critical the income source is to a family or business, and the more people rely on it, the larger the fund is required.
The amount of someone's wealth does not dictate whether you have an emergency fund. The emergency fund is there for unexpected liquidity emergencies and prevents long-term investments from being sold in the event of an unforeseen lapse in income.
Actor Robert DeNiro's financial troubles this month highlight this critical fact. Mr. DeNiro has a reported net worth of $500 million and will earn over $7 million in income this year. As his attorney Caroline Krauss explains, "These people, in spite of his robust earnings, have always spent more than he has earned so this 76-year-old robust man couldn't retire even if he wanted to because he can't afford to keep up with his lifestyle expense." In short, due to the pandemic and unexpected loss of income at two of Mr. DeNiro's New York City businesses, Nobu and The Greenwhich Hotel, along with a pause in movie production, he is finding himself in an unexpected liquidity squeeze.
Where to Keep Your Emergency Fund
Emergency fund investment options provide liquidity and safety as the primary focus rather than a high return. Traditionally, emergency funds were deposited in a bank money market account, or savings account since both provide the benefits of FDIC insurance up to $250,000, liquidity, and earn interest (although minimal).
An alternative to traditional brick and mortar bank accounts are online savings accounts from large reputable banks. These generally offer more competitive interest rates and carry the same FDIC protection.
We offer our clients Flourish Cash, an online account linked to your bank account, and offers competitive rates that adjust quickly to Federal Reserve rate changes.
Like a bank money market account, money market funds may also provide a solid emergency fund investment choice. While not offering FDIC insurance, they do have a high level of safety with investments typically in short term government treasury or agency bonds.
Also, they have liquidity when needed as they can be bought and sold with funds becoming available often the next day.
While money market funds are considered low on the risk scale, they are not without any risk. A money market fund's manager attempts to keep the fund's price at $1.00 per share, but this is not guaranteed and should be understood before investing in any fund. Notably, a prominent money market fund did "break the buck" during the 2008 financial crisis, which led to reforms making the funds safer, yet still not without some risk.
With the current interest rate environment being so low, some investors have looked beyond bank accounts and money market funds to ultra-short-term bond funds for a potentially higher yield.
Investing in an ultra-short-term bond fund would require some due diligence to ensure you are choosing an appropriate fund, as they are not as regulated as money market funds and have increased flexibility as to what they can invest.
Typically, these funds look to venture a little further out on the risk scale with bonds from entities such as corporations that may have lower credit quality or longer durations that can add to their yield and carry additional risk.
Doing your research before investing in any bond fund is prudent, as they can differ significantly. However, some ultra-short-term bond funds have performed well and maintain stability, making them a potentially suitable emergency fund option.
Two less considered options that are not necessarily emergency funds but would be helpful during an unexpected loss of cashflow are a home equity line of credit or securitized loan on an investment portfolio. Both are open lines of credit that generally offer low-interest rates and can be drawn on when needed.
Since both collateralized to an underlying asset with a fluctuating value (a home or investment portfolio), you would have an added variable to account for should either decline in value. Yet, over more extended periods, both home and stock prices generally have increased.
Some potential downsides to these two options are they are not available to everyone. Those that are not homeowner's or have investment portfolios large enough to justify a securitized loan cannot take advantage of these two alternatives.
Additionally, with both, you are adding debt and will pay interest on that debt. Although rates are low, adding to the debt during a time of reduced or no income could exacerbate an already bad situation.
In 2006, then CEO of Ford, Alan R. Mulally spoke to investors and negotiated a deal to raise over $26 billion of loans that would provide "a cushion to protect for a recession or other unexpected event." His prudent planning helped Ford avoid bankruptcy during the financial crisis, which engulfed rivals GM and Chrysler and points to the benefit of having an emergency fund for the unexpected. With smart planning, individual investors can benefit from the same forethought and be prepared for unexpected life events, even a global pandemic.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.