Harold Wilson, former British Prime Minister, quipped: “I’m an optimist, but I’m an optimist who wears a raincoat.”
You probably already have some cash saved for the inevitable rainy day. In fact, you should have savings for those one-time, non-recurring expenses that come up (water heater replacement, roof repair, car insurance deductible), but these savings should actually be separate from your emergency funds.
It’s critical, especially as you prepare for retirement, to have extra funds for financial storms that could wreak havoc on your lifestyle.
Your emergency fund is a key component to the solid foundation of your financial plan. Having this money prevents you from racking up credit card debt, accessing your retirement accounts, or selling assets to pay your bills.
You must have twelve months of living expenses set aside in a safe, liquid savings account. Remember, the purpose of this money is not to make money but to be there for you in a true emergency. Do not take risks or give away liquidity for a small profit. A savings account is your best bet, just remember to stay within the FDIC insurance limits at each bank.
It’s important to calculate how much you’ll need in your emergency fund using your actual monthly expenses, not your monthly income. Different people earning the exact same salary may have very different monthly obligations.
For example, if you have no debt, no dependents, and live fairly frugally, you can probably allocate less to this “bucket” and invest more of your money. On the other hand, if you have three children to support, along with a hefty mortgage and credit card bills to cover, your emergency fund would be a bit more bloated.
You can use the free online financial planning tool, My Financial Plan, available from Snider Advisors, to help you determine the correct number.
An emergency fund should only be used in the event of a salary interruption or variations in portfolio income. When you’re employed, this means you shouldn’t withdraw your emergency funds unless you’ve lost your job, an illness or disability that prevents you from working, the death of a spouse, or a leave to care for an elderly or sick family. affiliate, or any other circumstance that seriously affects your income.
Once you retire and start living off your investments, natural fluctuations in the economy and financial markets will create fluctuations in your retirement income. Your emergency fund will make those fluctuations manageable. Cash is your most effective tool for smoothing out the effect of market volatility on your retirement income.
Let’s say you need $4,000 a month from your portfolio to cover your living expenses in retirement. You have a portfolio of $1 million that produces an average annual return of 7% over a long time horizon. That works out to $5,833 per month, before compounding.
In normal times, you would withdraw $4,000 per month from your portfolio, leaving the remaining $1,833 per month in earnings in the portfolio. The reinvested dollars create the growth you need to keep up with inflation.
Now imagine the economy and the stock market crashing. The returns on your investment, over a period of time, drop to $2,000 per month. What do you do for a living? You do not sell the assets at a loss. This is called eating your principal, and it results in a very bad situation for retirees called reverse compounding.
Instead, you take the $2,000 in earnings out of your investment portfolio. You make up the difference, between the $4,000 per month you need and the $2,000 per month the portfolio is currently producing, using your emergency funds. That’s why you set them apart. Being smart and careful with your money, you know that this type of variance will occasionally occur.
After a period of time, the market begins to improve a bit, and the returns on your portfolio increase to $3,000 per month. You are now supplementing your portfolio returns with just $1,000 a month from your emergency funds.
Eventually, because we assume that stock markets are mean reverting, which means they cannot exist indefinitely in an extreme state, your portfolio returns come back in line with the portfolio’s expected rate of return. At that point, you are no longer supplementing your portfolio returns with your emergency funds.
The nature of mean reversion is that the pendulum swings both ways. So, just as we had a period of underperformance, we expect there will also be periods where the portfolio outperforms.
What do you do during these boom periods? Do you spend the extra money on new cars and fancy vacations? No. You use those time periods to replace what you took from your emergency funds so that when the next economic downturn hits, you have enough reserves to smooth out the income in your portfolio.
This system for managing the variability of the portfolio in retirement is very easy and very effective. Similarly, you can more easily weather a temporary interruption in your salary during your working years with emergency funds as a buffer.
Planning, in almost any company, is the key to success. It’s great that you have your raincoat and umbrella for the rainy day, but in the event of a flood, your emergency savings will be your coffer.
This is not financial, legal or tax advice. Our goal is your financial success, but all investments involve risks, including the possible loss of principal, and results will vary. If you are interested in the Snider Inversion Method, please read the Owner’s Manual for a full description of the risks and benefits. More information can be found on our website or by calling 1-888-6SNIDER. Past performance is not indicative of future results.
