Establishing An Emergency Fund Target

In Cash Flow and Budgeting, General Financial Planning, Personal Finance, Personal Financial Planning by Chip Hymiller

How much cash is it appropriate to keep on hand in short term savings and money markets?  Before we address the question, it is important to understand the important role cash plays in an overall financial plan.

What is the purpose cash?

We are often reminded by client that interest rates on cash and money market is miserable.  While it is important to periodically “comparison shop” rates, it is also important to remember that the real purpose for maintaining cash is not to provide a rate of return, but instead to provide liquidity.  Liquidity can embed a margin of safety and flexibility within the context of an overall financial plan.

Over time it is important to assess your cash needs systematically.  We believe, that when it comes to thinking about emergency funds and how much cash to keep on hand, we suggest a 3 step approach as follows:

Step 1: Establishing an Emergency Fund Target

A common rule of thumb for an emergency fund target is 3 to 6 months of living expenses.  However, it is important to point out that there are certain situations that would warrant higher emergency fund target amounts.  Those in high risk occupations, single income families and people with rental investment property should certainly account for their additional financial risk when deciding on an emergency fund target.

In terms of calculating an emergency fund, a family needs to first assess required monthly living expenses.  Some are daunted because they believe an emergency fund should include 6 months of gross income.  However, we include only the required monthly expenses and exclude certain items like savings, retirement contributions, taxes, and discretionary spending (i.e. vacations).  Once  you have identified the required monthly expenses, multiply that number by the number of months that give you a comfortable cushion.   The result is your emergency fund target.

Step 2:  Maintaining Cash for Anticipated Expenses

In addition to an emergency fund, we suggest that those who are taking periodic distributions from their investment portfolio (i.e. retirees), should also maintain cash to cover anticipated withdrawals.

The amount of cash to retain for expected withdrawals will vary based on an individual’s risk tolerance.  However, we normally suggest that people keep at least one year’s worth of disbursements (and normally 5 years) in cash, stable value or other very short-term “risk free” investments.  Doing so, will enable those taking distributions to avoid being forced to sell an investment (that may have declined in value) in order to fund living expenses.

Step 3:  Reassessing Cash Targets

It is important to periodically reassess the amount held in savings.  Changes in circumstances (job change, new house, children, etc.) may result in an increase or decrease in the level of cash to be kept on hand.  Additionally, it is important to monitor interest rates earned on your cash accounts.  A 1% difference in interest earned can make a huge difference over long periods of time.

Please contact our office should you have any questions or would like to discuss your emergency fund target in the context of your overall financial planning objectives.