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Just How Much Is Enough For Your Emergency Cash Fund?

Christine Benz, Emergency Cash Fund

With Christine Benz, Director of Personal Finance at Morningstar, Author of author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and The Morningstar Guide to Mutual Funds

Emergency Fund Amount Depends On Your Life Stage

Christine Benz, noted author and Director of Personal Finance at Morningstar, joins the show again today, this time to talk with Steve about emergency cash reserves and how much you should have stashed away, depending on various factors, and in what kind of “instruments” or assets.  Steve and Christine, both Certified Financial Planners, acknowledge that the conventional wisdom in their field is that people should hold 3 to 6 months’ worth of living expenses in cash, a recommendation Christine calls a “blunt instrument.”   A better approach, they agree, is more nuanced and flexible, and Steve asks Christine to start with a question she wrote about in a recent article: “What is your life stage?”  At its most basic, the life stages that matter the most are being in the workforce versus being retired.  A person working full time needs less of a cushion than those who aren’t bringing in income outside of savings or investment withdrawals and can probably get away with the generic advice of 3 to 6-month expenses in cash reserves.  For retirees, Christine’s guidance is to hold one to two years’ worth of “true cash instruments.”  The main reason for this large difference is that retirees should not put themselves in a position where they would need to sell savings portfolio securities like stocks or bonds into a down market.  Without other sources of income, you want to have enough liquid assets (cash or cash equivalent) to tide you over through inevitable but unpredictable market slumps.

Are Short To Mid-term Bonds A Safe Alternative To Cash?

Steve wonders how realistic it is for retirees to keep that much cash “on the sidelines” for that long—earning next to nothing in a deposit account or money market fund—when this money could be more productive without taking on much risk, namely in the form of short or intermediate-term bonds.  Christine allows that some of the cash cushion could go into bonds of this type, but she makes the counterpoint that these will yield only a few extra basis points and expose you to interest rate risks where bond prices could decline if interest rates rise, setting you up for losses unless you’re able to wait for the bonds to mature.  The potential losses may not be great, but is this risk worth the anemic advantage in yield?  In a worst case scenario, while not likely, both stocks and bonds could suffer a simultaneous decline, further restricting retired investors options.  A diversified portfolio should include cash because the chances of equities, bonds, and cash all ailing at the same time are even less likely.

Income Stability And Emergency Fund Amount

After the life stage question, the second question to ask is “how stable is your income?”  Christine notes that this is especially relevant of late because more people than ever are participating in and dependent on the gig economy and their income is often intermittent and unpredictable.  The money might be very good for months and then all of a sudden dry up, leaving you with no income for a few months.  For those people whose income is “lumpy,” it’s even more imperative to set aside enough cash.   You don’t want to raid your retirement accounts to pay for everyday living expenses.  Steve takes this a bit further, arguing that people who work in cyclical industries are particularly vulnerable to a situation where they lose their job and therefore need to draw on the retirement savings they have in a 401(k) plan at the same time that the stock market is crashing or performing badly.  If you know your industry is cyclical, then you ought to set aside more cash to cover the inevitable loss of income in down cycles and to insulate you from having to sell long-term assets.

Household Income: One Or Two Earners

Another important aspect to the emergency reserve question is whether you are the sole earner in your household.  Dual income families are, of course, sheltered from the possibility of a total loss of income because the chances of both earners losing their jobs at the same time are pretty slim.  If your income accounts for all or the lion’s share of the family income, however, Christine thinks you should have a larger cash cushion.

“Cash Instruments,” Liquidity, And Other Funding Sources

Steve asks Christine to unpack the issue of cash and how to define it and access it.  Her reply is that the money you have in checking and savings accounts at your bank is cash, and funds in money market accounts, online savings accounts, and to a large extent CDs (certificates of deposit) are also all “true cash instruments.”  Short-term bonds or bond funds are semi-liquid and might be the next line of reserves after your cash is depleted.  There may be more sources of funds you can liquidate if you had to, short of selling retirement assets.  A home equity line of credit is one such source of cash.  A Roth IRA has certain advantages over 401(k) plans if you needed to pull money out of it, untaxed, at any time and for any reason, though this should still be thought of as a near last resort since it does take funding away from your future.  Steve takes a moment to drive home the importance of understanding liquidity, which refers to the ease and speed with which something can be turned into cash.   On one end of the spectrum would be the instant withdrawal of cash with no fees or penalties from a deposit bank account, and on the other end would be your home, regardless of whether you own it outright.

Cash Reserve For Future Investments

Steve wraps up the conversation by mentioning that some well-to-do folks keep cash on the side so that they might take advantage of an investment opportunity sometime in the future.  Warren Buffett, for example, has about $95 billion sitting around because he doesn’t see any assets that he wants to buy with it.  You might have a few billion less than he does standing at the ready, but it’s not a terrible idea to emulate if you don’t like the present-day risks and returns of the major asset classes: equities, bonds, real estate, or other forms of ownership.  Maybe you just want to wait until other people start selling before you consider buying, as for example if the stock market dips and you see a chance to put a little more money into play.  Christine thinks this is a smart strategy and expands on it by suggesting that you could go further create a “watch list” of investment ideas that trigger you to evaluate an opportunity when certain assets hit target prices.  Having cash on hand and a list of ideas at the ready could be an excellent way to both buffer you from market fluctuations and life surprises and position you to take advantage of long-term opportunities.

Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital.  Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions.  Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances.  The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.

Read The Entire Transcript Here

Steve Pomeranz: I know you’ve all heard of Morningstar.  And one of Morningstar’s stars is Christine Benz, Director of Personal Finance and author of two books, 30-Minute Money Solutions, a Step-by-Step Guide to Managing Your Finances and The Morningstar Guide to Mutual Funds.  Hey, Christine, welcome back to the show.

Christine Benz: Hi, Steve, good to talk to you.

Steve Pomeranz: Today I want to talk about how much cash for emergencies a person should put aside.  Some people say three months;  some people say six months.  It seems like those answers are a little too simple.  How do you look at things?

Christine Benz: Yeah, I do think it’s important to customize your cash holdings to your own personal situation.  I know the old rule of thumb, the one I learned in the certified financial planner program, was three to six months’ worth of living expenses.  That’s what everyone needs.  It’s a blunt instrument.

Steve Pomeranz: Yeah [LAUGH].

Christine Benz: Many people need significantly more than that.

Steve Pomeranz:  All right, and it’s not quite so simple.  It takes a little bit more complicated thinking.  So, let’s take us through that.  The first question you wrote in a recent article was “what is your life stage?”
What does that mean?

Christine Benz: Well, it really depends on whether you’re working and still earning an income or whether you’re retired.  So, for people who are still earning an income, maybe employed in some sort of a full-time setting, they may be able to get away with a lower cash cushion, maybe three to six months or something in that discount hydrocodone no prescription ballpark is reasonable.

For people who are retired, I typically recommend one to two years’ worth of true cash instruments.  And the basic idea there, the reason as a retiree you’d want to hold more is that you could encounter a poor stock market or maybe a terrible bond market, where we see bond yields shoot up and that hurts bond prices. You don’t want to be a seller in those environments.

You don’t want to have to sell your securities to meet your living expenses.  You want to have enough liquid assets on hand to tide you through those weak periods for the markets.

Steve Pomeranz: So let’s talk about that. As a retiree, I think having one to two years in cash, when cash is earning next to zero, would be problematic. Would you agree to accepting short or intermediate-term bonds?

Christine Benz: Possibly with a portion of the cash cushion.
The thing I look at today is that when you’re venturing into some sort of a bond product, you have interest rate risk, and yet yields aren’t substantially higher than you can earn on a cash account today.  So, you might be able to find an online savings account that can give you 1%. Well, even in a high-quality short-term bond fund.

Steve Pomeranz: Yeah.

Christine Benz: Might be at 1.5%.

Steve Pomeranz: Right.

Christine Benz: So, you kind of have to weigh, am I willing to take the interest rate risk there, the risk of having a little bit of a loss relative to my ability to pick up a little bit more yield?

Steve Pomeranz: Yeah, and you’re talking about a double whammy.  You’re talking about not only the stock market going down, so there’s no money.  You don’t want to draw from your stock portfolio while it’s down.  And then you think, “well, I’ve got my bonds.”  But you’re thinking also, “well, if we have this rapid rise in interest rates, then bond prices are going to go down.”

There’s a relatively low probability of both happening.  It has happened.  It doesn’t happen very often, but that’s what the cash would be for, for that probability of both markets being down, okay.

Christine Benz: Right, right, because, as I said, you just don’t want to be a seller in such an environment. But diversification is the name of the game.  You want to have bonds.  You want to have stocks.  You want cash because the probability of everything being down at any given point in time is really low, especially cash, obviously.

Steve Pomeranz: Okay, so we talked about life stages.  The second question you want to ask yourself is how stable is your income?

Christine Benz: Right, yeah, it’s a really important consideration today because you have so many people who are participating in the gig economy in some way.

Steve Pomeranz: Mm-hm.

Christine Benz: I’ve got more and more friends who have taken on work as contractors, and it can be really lucrative while they’re working.
The crucial point to make, though, is that they might sometimes have significant disruptions in their income, where they might go without a job for three months or so.

Steve Pomeranz: Yeah.

Christine Benz: So, if you are someone whose income tends to be lumpy for whatever reason, it’s crucial to have enough cash set aside.

Steve Pomeranz: Absolutely.

Christine Benz: So that you’re not having to invade your retirement assets or your other long-term assets just to meet your living expenses.

Steve Pomeranz: Yeah, this is something that’s very important.  It’s a little bit off topic, but it’s something that I’ve thought about that many people do not talk about.

And the fact is that when you have your long-term investment assets like your 401k and you have a job that’s not necessarily stable—let’s say it’s in a cyclical industry—the worst thing that can happen to you is that you lose your job and, at the same time, the stock market is down because the economy is weak. Perhaps that’s the reason you’ve lost your job.  And now you have to dip into your 401k at the worst possible time when stocks are depressed and it’s a double whammy.  So, that’s why, if you have a cyclical type of job or you work in a cyclical industry, it’s really good to have more cash outstanding than I think a person in a more stable industry would need.

Christine Benz: That’s such a good point.  The investment, philosopher, writer, Bill Bernstein has called the definition of risk, bad returns in bad times, right?

Steve Pomeranz: Yeah.

Christine Benz: That’s why you hold cash to help ensure that you’re not having to, that you’re not losing your job in a bad market and then having to sell stuff, sell securities in that weak market as well.

Steve Pomeranz: My guest is Christine Benz.  She is Director of Personal Finance at Morningstar.  Christine, so here’s another one.  Are you the sole earner in your household?  Why is that important?

Christine Benz: Well, it’s important because, if you are part of a dual income family, that means that you have at least one other income still coming in the door.

It’s very unlikely that you would both lose your jobs at the same time.  So, it does provide a little bit more buffer than the person who’s the sole earner.  If you are the main person earning a salary in your household, I think that argues for having a larger cash cushion than the person who’s part of the dual-income family.

Steve Pomeranz: Yeah, the chances of both of you losing jobs is a much lower probability than just one person.  That’s for sure.

Christine Benz: Exactly.

Steve Pomeranz: Yeah, okay.  Question here, can you access cash in other ways?  When we talk about cash, we discussed this a little bit before,  but what are we talking about? What is cash to the average person?

Christine Benz: Well, cash is your checking and savings account.  You might have CDs, money market accounts, online savings accounts.  Those are true cash instruments.  You mentioned short-term bonds.  If you had some sort of a high-quality short term bond fund, that might be next line reserves, in case your cash cushion was depleted.

And then you might think of additional sources of funds if you absolutely needed them.  So, a lot of people hold a home equity line of credit for this very reason.

Steve Pomeranz: Mm-hm, right.

Christine Benz: That, in case they lose their jobs, they’d rather have that HELOC available to them than have to apply for it when they don’t have a job and are unlikely to have that line of credit extended.

So, a HELOC would be one idea.  Another thing I often tell young people to think about is, start a Roth IRA.  Because while you don’t want to have to raid it and you want to leave the money to grow for your retirement, worst case scenario, you can withdraw your contributions at any time and for any reason.

Steve Pomeranz: Yeah, yeah.

Christine Benz: So, that’s another potential source of funds.

Steve Pomeranz: I think the key word, and this is a word that I want everybody to know and to learn, is liquidity, the ability to turn something into cash immediately.  That’s why a checking account and savings accounts are highly liquid. I guess, even to a certain extent, a long-term CD, even though there may be a penalty associated with turning it in, it’s still liquid.  And you’ll still get your money back.  You’ll just get a little bit less interest.  And this would be different than your home, for example, which is incredibly highly illiquid if liquidity is defined as the ability to turn money into cash on a moment’s notice.

What about keeping cash aside for the opportunistic investor?  I know that I was just at the Berkshire Annual Shareholders Meeting.  And Warren Buffett was up there.  And he was saying he’s got $95 billion in cash waiting for opportunities.  I think the rest of us have a significantly less amount.
[LAUGH] But what about this idea about leaving cash aside for investment opportunities?

Christine Benz: I think that it’s a perfectly reasonable idea.  Certainly, when we look across the best investment managers, in addition to Warren Buffet, that’s one commonality that I see among many of them is that many of them are willing to say, “you know what? I think that the markets, I’m just not finding a lot to buy in today’s market. I’m going to wait until other people are selling, and that’s when I’ll dive in.”  So, I think for individual investors, especially now, given that we have had this tremendous ascent in the US market, investors too, perhaps, want to keep a little extra aside and know that they will deploy that money into the stock market if it takes a dip.

I think that’s a perfectly reasonable strategy.  In fact, I like the idea of also compiling a watch list.

Steve Pomeranz: Mm-hm.

Christine Benz: Whether you’re an individual stock investor or someone who invests in bonds, that you might say, “I really like the way that this manager manages assets. I just don’t want to commit additional assets to the US market right now.” Go ahead and compile that watch list.  And in addition to having your cash ready, you also have some ideas ready.

Steve Pomeranz: Good advice from Christine Benz, Morningstar’s Director of Personal Finance.  Thanks so much for joining us, Christine.

Christine Benz: Thank you, Steve, always a pleasure.