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By Steve Lowrie, CFA
Special to Financial Independence Hub
Having an emergency fund is common advice, whether you are reading this in the financial media or hearing it from a financial advisor. Many people who are later in life and feeling comfortable with their financial situation might disregard this advice, assuming it only applies to those that don’t have as much financial stability.
The truth is that an Emergency Fund is something that everyone (even you!) should have. In addition, the added financial security planning of a Lifestyle Reserve should also be part of your financial plan. So, let’s explore exactly what an Emergency Fund is, how a Lifestyle Fund is different, and why both should be in place to ensure long-term financial alternatives and adaptability. Most importantly, I’ll highlight how this applies to Suzie & Trevor Hall (The Accumulators) and Jim & Carol Oates (Almost Ready to be Retirees), so you can see how it can work for you.
What is an Emergency Fund / Rainy-Day Fund / Financial Cushion and Why do I Need it?
Let’s talk about an Emergency Fund, which is often used interchangeably with Financial Cushion or Rainy-Day Fund. They are close but have slightly different purposes. An Emergency Fund / Rainy-Day Fund is a safety net for unexpected financial surprises; this could be an immediate need to replace a furnace or roof, an unforeseen job loss, or a medical condition requiring unpaid time off from work. An Emergency Fund / Rainy-Day Fund would generally be kept in cash in a separate account from day-to-day-expenses, usually in a high-interest savings account.
On the other hand, a Financial Cushion is more of a buffer to cover elevated or lumpy day-to-day or month-to-month costs like a higher than usual heating or grocery bills, etc. A Financial Cushion is often kept in the main bank account in cash, just to keep a financial safety margin-of-error to allow for a secure feeling about covering regular expenses.
Whether we say Emergency Fund or Rainy-Day Fund or Financial Cushion, they are similar, so let’s simplify the definition: a liquid/cash reserve to cover unforeseen and unbudgeted for expenses which allows for financial stability and peace of mind.
You may already have this is place, without formal planning. The next question you should ask yourself is whether you’ve set up your Emergency Fund / Financial Cushion in a way that truly provides the stability and comfort that you need.
Before we dive into that, let’s hear what New York Times Bestselling author and one of MarketWatch’s 50 most influential people, Morgan Housel, shared in his book, The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness:
“The biggest single point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.”
How much should my Emergency Fund be?
So, let’s explore some questions about an Emergency Fund:
- How much of an Emergency Fund / Financial Cushion is needed?
- How long will it take to build a strong Emergency Fund /Financial Cushion?
I know you hate to hear it but, as with many financial planning questions, the answer is “It depends!” But I won’t leave you hanging; let me give you an idea of factors to consider when building your Emergency Fund:
- Current and Future Financial Outlook: Have you just started a new business and don’t have a good handle on your upcoming income? Alternately, do you have a stable job that you feel fairly confident on relying on that income for the foreseeable future? Another consideration is potential upcoming surprises – Is a new baby on the horizon? Will your grown kids need financial support? Do your properties and/or vehicles have any approaching maintenance or replacement needs? Or, do you have parents who may need financial support as they age? Keeping these, and other potential unforeseen expenses in mind, will help you determine the ideal size of your Emergency Fund; at least 3-6 months of necessary expenses is ideal, but a 1-month Emergency Fund might be appropriate, in some financially stable situations.
- Risk Tolerance: The size of your Emergency Fund / Financial Cushion is also dependent on your own personal financial risk tolerance. Although some people may feel completely comfortable with 1–2-months of necessary expenses for their Financial Cushion, others may feel the strong urge to keep 12 months aside. Whatever the amount is that will allow you to sleep at night is a good indicator.
- Balancing the Budget for Current & Future Needs: How quickly you can build your Emergency Fund is highly dependent on how much of your existing income can be diverted to fund it. That may mean reallocating a portion of your long-term savings or tightening the discretionary spending belt until you’ve built your Financial Cushion to the level of comfort you need.
- Opportunity Cost: Some people want to hold too much in cash, which may be a financial security blanket, but keeping more than needed is detrimental in the long run because “money in the mattress” could be used to build wealth. So, when deciding how much your Financial Cushion should be, consider that keeping too much will cost you in lost investment opportunity.
To hammer home the importance of an Emergency Fund / Financial Cushion and the financial benefits it provides, let’s hear a little more advice from Morgan Housel in The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness:
“Saving does not require a goal of purchasing something specific. You can save just for saving’s sake. And indeed, you should … Saving is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment … Savings without a spending goal gives you options and flexibility, the ability to wait and the opportunity to pounce. It gives you time to think. It lets you change course on your own terms.”
“Six months’ emergency expenses means not being terrified of your boss, because you know you won’t be ruined if you have to take some time off to find a new job.”
Even though everyone’s talking about Emergency Funds and Financial Cushions (and that’s a great starting point), let’s look at the bigger picture and think about long-term financial security. To do that, we want to focus on Lifestyle Reserve.
What is a Lifestyle Reserve / Cash Wedge and Why do I need it?
You may have heard me talk about a Lifestyle Reserve in my previous blogs, Using a Lifestyle Reserve To Ride Out Market Storms and Play It Again, Steve – Timeless Financial Tips #6: Aligning Your Investments with Your Investment Time Horizon. A Lifestyle Reserve, or sometimes referred to as a Cash Wedge, is essentially enough money in safe investments to cover your spending needs; this can be (and often is) at retirement or it could also be needed to supplement income in working years to meet your lifestyle needs. For clarity, I’m talking about the lifestyle to which you’ve become accustomed or the level of lifestyle you want, which would include both “needs” spending (non-discretionary) and “wants” spending (discretionary). So, your lifestyle needs would include vacations, club memberships, gifts to kids, charitable donations, etc.
A Lifestyle Reserve / Cash Wedge should be secured in a low-risk manner: cash or high-quality, short-term fixed income investments, which may produce a lower-than-expected return on investment but is exposed to significantly less volatility to ensure that your principle is preserved.
Another reason for maintaining a healthy Lifestyle Reserve is that, if (or when) there is a pull back or correction in equity markets, a robust Lifestyle Reserve allows you fund your lifestyle needs without having to sell equities when prices are down. While there is a lot of variability with this, historically it has taken anywhere from 1 to 3 years for prices to fully recover after a market correction. By keeping your Lifestyle Reserve / Cash Wedge safely invested, it allows you to place a larger amount of your long-term savings in more growth-oriented investments with the potential for bigger returns. Without an appropriate Lifestyle Reserve, you may end up selling your equity investments when prices are down to meet your lifestyle needs, i.e. selling low. A Lifestyle Reserve allows you to draw the cash you need to meet your lifestyle needs and sell your equity investments at more opportune times.
How much of a Lifestyle Reserve should you build?
You want to build enough of a Lifestyle Reserve that you could cut back minimally on discretionary spending so you can manage financially but your lifestyle doesn’t suffer significantly during turbulent times. A Lifestyle Reserve is not just a concern for Retirees. You’ll want to start planning and building it many years before retirement.
As a rule-of-thumb, your Lifestyle Reserve should cover 2-5 years of your spending needs. That’s a good starting point, however, it really does depend on your circumstances.
You’ll want to consider the level of lifestyle you are planning for and the associated costs.
For your retirement years, you would want to consider expected income like government benefits and pensions. Then, your Lifestyle Reserve should be calculated on the over-and-above figure you would need to meet your lifestyle needs. So, if your yearly lifestyle goal is $150k/year and you’ll get $50k/year in government benefits and pension, you would need to your investments to provide you with $100K per year. Using the 2-to-5-year guideline, this would result in a lifestyle reserve of $200K to $500K.
Lastly, keep in mind that you may have a certain risk tolerance in your 40s that may be substantially lower in your 70s, so you’ll want to take that into account in the planning of the size of your Lifestyle Reserve.
You’ll want to work with an independent financial advisor to factor in inflation, taxes, discretionary spending (travel, charitable giving, etc.), your unique risk tolerance, and your financial capacity to take on risk in the first place.
Now that we have a good grasp on Emergency Fund / Financial Cushion / Rainy-Day Fund and Lifestyle Reserve / Cash Wedge, let’s see how they would apply people in different financial stages of their life…
The Accumulators: Suzie and Trevor Hall
- Emergency Fund: Absolutely necessary. Likely 3-6 months of necessary expenses – but can range from as low as 1 month to as high as 12 months, depending on their current/future financial outlook, risk tolerance, and balancing the budget for current/future needs.
- Lifestyle Reserve: Not active, in “accumulation mode.” The Halls should be building a Lifestyle Reserve within their investment portfolio, especially the closer they get to retirement. The amount of the Lifestyle Reserve they would build is likely 2-3 years of lifestyle spending expenses but will vary depending on their investment timeline and risk tolerance.
Almost Ready to Retire: Jim and Carol Oates
- Emergency Fund: Although important, the Oates’ Emergency Fund would be less critical than that of The Halls because there would not be as many income-wavering factors (e.g., job change) affecting them. It would also depend on their risk tolerance and living situation. For example, if they own multiple properties that require maintenance, they would need a much larger Emergency Fund (6-12 months of necessary expenses) vs. a condo living situation in which their Emergency Fund could be only 1-2 months because financial emergencies would be far less likely.
- Lifestyle Reserve: Built up and active. The Oates would want to maintain a Lifestyle Reserve of 2 years of lifestyle spending expenses, at an absolute minimum but it could vary depending on their risk tolerance and comfort level. It could be as much as 10 years – it may not make financial sense due to investment opportunity cost, but the Oates might need a sense of long-term security. It’s not optimal but gives them comfort and lets them sleep at night.
Occasionally, the strategy of using a HELOC (Home Equity Line of Credit) is an option, versus keeping cash in an emergency fund. This isn’t optimal but may be appropriate to consider for people on opposite ends of the spectrum. For example, if someone is having trouble saving up for an emergency fund but have equity in real estate. Or, if they have substantial equity built up in real estate and can easily pay down an HELOC balance over time through other sources. But, this is only a potential strategy for the disciplined; it’s a good idea to discuss with an independent financial advisor.
Savings Tools like a Rainy-Day Fund and a Cash Wedge are Critical for Reducing Financial Risk and Mitigating Short and Long-Term Financial Disaster
Here’s a final thought from Morgan Housel in The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness:
“Getting money is one thing. Keeping it is another … Keeping money requires the opposite of taking risk. It requires humility, and fear that what you’ve made can be taken away from you just as fast.”
Having saved money set aside to account for risk isn’t a short-term strategy — it’s a lifestyle. And hopefully, a financial lifestyle that you now know applies to you and are ready to commit to.
Balancing your savings between emergency savings, “buffer” savings, lifestyle reserve, and long-term investments can help cover the bases and ensure a stable, long-term wealth building strategy.
Steve Lowrie holds the CFA designation and has 25 years of experience dealing with individual investors. Before creating Lowrie Financial in 2009, he worked at various Bay Street brokerage firms both as an advisor and in management. “I help investors ignore the Wall and Bay Street hype and hysteria, and focus on what’s best for themselves.” This blog originally appeared on his site on March 27, 2024 and is republished here with permission.
