Emergency Fund 2.0

What’s this? A personal finance blog post about Emergency Funds? How unorthodox! What a novelty! Such a trailblazer! Sarcasm aside, we appreciate that the Emergency Fund is a topic done to near-death; it’s perhaps the quintessential personal finance trope. So we’ll try to concisely cut through the usual waffle that you’ve probably read before and focus on what we found more interesting: alternative strategies.

Déjà vu all over again

If you maintain a ‘traditional’ emergency fund you’ll be following the advice of some reputable names, be it financial bloggers (including Monevator‘s The Investor, The Escape Artist and The Frugal Cottage), authors (such as Andrew Craig and Tim Hale), podcasts (such as Meaningful Money and Maven Money) or pretty much any other financial resource (e.g. the Money Advice Service). In terms of how large an emergency fund to have, three months’ expenses is about the average of a broad spectrum of recommendations. The ‘where’ is typically a highly secure, highly liquid, highly accessible asset, which invariably means a cash-equivalent, easy-access account.

Reasons for…
• Prepared for financial emergency
• Have a form of income security/insurance
• Reduced risk of having to use credit or take on debt
• Peace of mind
• Development of financial discipline and restraint
• Confidence to place your other savings in riskier vehicles e.g. equities

You’d be keeping equally exalted company if you refrained from hoarding three months’ of expense in cash, joining an international cast that includes ‘Murican FI heavyweights MMM, ERE, Big ERN and Physician on FIRE, as well as representatives from Canada, continental Europe, The Antipodes and the UK’s very own vulpine blogger, The FI Fox. They cover the gamut of reasons to reject the traditional model and suggest various other methods of financial emergency preparedness.

Reasons against…
• Opportunity cost 1; loss of financial growth by having money uninvested
• Inexorable loss of value as inflation almost certainly higher than interest on cash
• Opportunity cost 2; loss of growth by having to re-build the fund after an emergency
• Temptation factor; spending the money on non-emergencies
• Reduced portfolio efficiency
• Incomplete budgeting & over-labelling events as ’emergencies’ increases required fund size
• One-size-fits-all model is redundant
• The distraction factor; saving for emergency fund distracts from other financial goals
• Demonstrations of benefit are guilty of hindsight bias
• Money is fungible; emergency funds are an example of mental accounting

Crunchin’ numbers

The nay-sayers have done the maths to back up their arguments. The performance of emergency funds held in various non-cash portfolios comes as no surprise. Majority bond/minority equity emergency funds, when compared to 100% cash, improve returns and minimise the loss of capital from volatility i.e. are more efficient.

Having a separate cash emergency fund has been found to increase the variability of the rate of return of one’s total portfolio, while including equities as part of an emergency fund strategy reduces the chance of the fund being inadequate1. Furthermore, the cost of borrowing in the event of emergency is likely to be offset by the improved return on investments. Indeed, a three month emergency fund may only be required for those with a reasonable probability of a significant (>50%) drop in household income2.

Factors that facilitate maintaining less of an emergency fund:
• reliable cashflow: stable job, dual-income household, additional income opportunities, passive income
• fewer or no dependents
• available credit and/or low cost of borrowing
• debt free
• adequate insurance and appropriate budgeting
• reasonable savings rate (or high ‘regular income to fixed expenses’ ratio)

A simple model3 has previously been used to answer the ‘should I have an emergency fund?’ question. Let’s say the chance of an emergency occurring is 100% i.e. guaranteed. We can plug in the [nominal] interest we’d expect on both our cash emergency fund (say 1%) and an alternative investment (say 7% for equities). We’ll set the cost of borrowing money at 20% APR (e.g. credit card). The output tells us that, using these figures, a 100% cash emergency fund is better only if emergencies occur every 10 months. Even if you could only muster 3% investment return (e.g. bonds), emergencies would have to be happening like clockwork every 12 months for the emergency fund to be worthwhile. Using a 60% chance of an emergency occurring annually, an emergency fund is only sensible if the rate of return on investments is within 1% of that for your cash. Food for thought, for sure.


Emergency Fund 2.0

If you have the risk tolerance to eschew the traditional approach, there are plenty of proposed alternatives to the classic one-pot, all-cash emergency fund. Easily the most popular is the pyramidal (a.k.a tiered) strategy. There are variations of which asset classes occupy the different tiers of the pyramid, though in essence they all favour low risk, highly liquid vehicles as the metaphorical capstone. As you descend the pyramid, the vehicles become higher risk, higher return and less liquid in nature. Such an approach is undoubtedly intuitive, although you may still have significant amounts of money earning poor interest in the upper tiers.

An example of a tiered emergency fund. Instead of holding the emergency fund as 100% cash, the money is spread amongst assets of varying liquidity and risk, in order to increase return. Credit cards should ideally be 0% APR and come with other rewards. Physical cash is sometimes recommended in case of system failures that preclude access to bank accounts. Easy-access and limited-access (e.g. Premium Bonds, regular or fixed-term savers) accounts are, at present, almost identical with respect to interest earned. The first investment tier is predominantly (if not 100%) bonds and held in a general investment account (GIA), so as not to sacrifice ISA allowance if you have to withdraw from it. Equities held in an ISA and real estate/home equity form the bottom tiers of the pyramid.

Another variation is what we’re going to call the credit shield-wall approach. Employing this strategy relies on two things:
1) Access to a suitable amount of credit. This might take the form of a credit card(s) or home equity (e.g. HELOC‘s in the USA – a UK equivalent might be using an offset mortgage account).
2) Reliable enough cashflow or high enough savings rate to ensure you can rapidly repay the borrowed money, ideally before any interest is accrued.

The ‘spongy debt’ acts a shield-wall against your other investments, allowing you to hold no emergency fund whatsoever; all of your spare cash is invested in the highest-return vehicle you can tolerate. The downside is that, should the shield-wall fail (e.g. not enough credit, credit card not accepted, multiple emergencies, concurrent reduction in cashflow), you may end up on the wrong side of compound interest and/or have to sell some of your other investments in a sub-optimal fashion.

The pyramidal and credit shield-wall strategies could be blended to form a sort of vanguard/rearguard (or Mayan temple) approach, with fewer, broader tiers that combine different asset classes. For example, cash and credit might form the vanguard, bonds and restricted savings accounts the middle guard, and equities (inc. home equity) the rearguard.

A ‘bond’ ladder emergency fund is perhaps more suited to the USA, given their access to CD‘s, but the theory is interesting nonetheless. You take the cash that would form your emergency fund and, instead of having it sit as a sad, depreciating lump, put it into fixed-rate savings accounts at regular intervals.

In practice
Let’s say your emergency fund would be £3,600. Instead of holding it all in one place, you put a twelfth of the cash (£300) into a 1-year fixed-rate account. The next month, you put £300 into a different 1-year fixed-rate account. Each month thereafter you put £300 into a different fixed-rate account until all of your £3,600 is used up. At the end of a year, the first account matures and, if you have no other use for the cash, you put it straight back into another fixed-rate account.

The beauty of this is that, once it’s all up and running, your emergency fund is in a perpetual cycle of accruing interest if it’s not used. The longest you’d have to wait for access to your cash is one month, during which time you can perhaps use other methods of financing an emergency. The drawbacks, however, probably outweigh the benefits. As well as taking a year to get up and running, the rates of interest on such accounts are so poor that it doesn’t really justify the loss of liquidity. A variant on this stratagem could be to use regular savers as well, although there are fewer options and their returns are only marginally better.

Emergent events don’t necessarily take a homogenous form; they aren’t always one-off, totally unpredicted, high cost occurrences. In reality one might suffer staccato low-cost spending shocks or a longer-lasting income shock. If emergencies aren’t of uniform nature, shouldn’t emergency funds reflect this heterogeneity? Enter, the trident approach. This multi-pronged, horses-for-courses method involves engaging the little grey cells initially, with the benefit of a more streamlined strategy at the end. Think about the different financial emergencies that you might face – estimate the cost of an event and the probability of it occurring. Next, place the money to cover that emergency in an appropriate asset class. You might end up with something like this:

Equities might be suitable for low-chance, medium/high-cost emergencies. For events that are more likely, the reduced volatility of bonds may be preferable. You might decide to use credit for medium/high-cost, high-probability events rather than holding large sums of cash. Cash is reserved for events that are low in cost but likely, to reduce over-reliance on credit.

This compartmentalisation of risk is more refined than using a large cash emergency fund to crack whichever walnut crosses its path. It’s by no means perfect, however, as the estimates you make are only as good the evidence they’re based on. Equally, believing a second low-probability event won’t follow soon after a first is akin to gambler’s fallacy and may scupper your best laid plans.

We stumbled across all sorts of wacky methods of how to optimise your emergency fund. The alternatives we’ve gone through are designed to give you a flavour of the spectrum of possibilities; emergency funds need not be a one-trick pony.

Decisions, decisions

Covid-19 has been financially polarising. Some are being kicked while they’re down. Others have engaged in financial reflection, revelation or even redemption. Either way, it’s demonstrated perfectly the need to be prepared for financial emergencies. The vast variation with regards to the extent, and nature, of required emergency funds mean there’s no ‘best’ or ‘winning’ strategy per se. Ultimately one’s emergency fund won’t just involve a strategy optimised for return, but will balance return against the behavioural aspects of your own personal finance too.


References
1 – J Scott et al. “Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” Journal of Financial Planning. 2013; 26(9); 56-62.
2 – YR Chang et al. “Emergency Fund Levels: Is Household Behavior Rational?” Association for Financial Counseling and Planning Education. 1997.
3 – CB Hatcher. “Should Households Establish Emergency Funds?” Association for Financial Counseling and Planning Education. 2000; 11(2): 77-85.


6 thoughts on “Emergency Fund 2.0

  1. Mebbe I am a scaredy-cat, but I tick quite a few of the boxes of factors for a smaller EF –

    no dependents
    debt-free
    passive income, reliable cashflow

    and yet I hold about three years’ running costs, and did throughout my entire living off investment and savings years. Why? because of correlation. Big emergencies happen in financial crashes. I was lucky to hang on to my job in the early 1990s when I saw both sides repossessed, I saw my job go bad in the GFC and retired several years early.

    I can understand the case for low/no EF when you are young and have decades of accumulation ahead of you, the opportunity cost is higher. But tempus fugit, and a big EF stiffens the spine in market turmoil like nothing else. Context is important IMO

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    1. Agreed – undoubtedly the low/no EF viewpoint is spurred by the vigour and optimism of those with a longer horizon. 3 years of costs seems like a lot of vertebral support, but I think I sometimes forget the (perhaps unparalleled) security of my job. As you say, context is king!

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  2. One thing I’ve found is that having that well stocked emergency fund removes a lot of the worries that other people presumably have. We don’t have to worry about how to pay the bills or buy food etc if for whatever reason I stop getting paid, and it means we can remain calmer and not as stressed about the situation, financially at least.

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    1. Thanks for your comment – you’re absolutely correct that one of the biggest pros of keeping an emergency fund is the psychological safety net, the peace of mind it provides. Balancing this behavioural aspect of one’s finance against optimising returns is entirely personal and why an ‘Emergency Fund 2.0’ may not be for everyone.

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