Financial & Estate Planning

Practical Finance: Rules of Thumb to Forget. Number Four….



You have no doubt heard this rule of thumb if you pay any attention to personal finance publications: Experts recommend setting aside three to six months’ worth of expenses in a savings account as a buffer against spiraling into debt should a disaster occur.

This is a great example of a good idea reduced to unfortunate over-simplification.

The idea of being prepared to cover unexpected expenses such as sudden car repairs, medical emergencies or job loss is undoubtedly a sound foundational principle. So, where’s the over-simplification?  Simplified to this: Every family’s situation is different, so the rule of thumb that says the correct prescription is three to six months’ worth of routine expenses is a shortcut that you might just as well dismiss.

Let’s re-invent a way to think about this important question in a more deliberate manner. If we break this down, it should become easier to make a bit more sense out of how to think about this financial issue in a sound way. Here’s an acronym that might be helpful: “SAVES”

  • S – SAGS & SWELLS HAPPEN. Be realistic when forecasting predictable outflows. In our 48 years of working with families, we’ve found that when we ask people what it takes for them to support their lifestyle in terms of average monthly outlays, a high majority underestimate the actual number on their first attempt. Why? Each expense is not month to month. Plot your spending on a graph — the line likely has many sags and swells. We refer to this as the “Battle of the Bulge”. When forecasting outlays, it is easy to forget about those “bulges” in outlays that are predictable, even though not monthly. Property taxes come due at the end of every year. Many insurance outlays tend to be annual in nature. Vacations and travel may be concentrated in certain months of the year. Most families have higher health care costs in the early part of the year when deductibles and out-of-pocket insurance limits reset.
  • A – ACCIDENTS HAPPEN. Most of us understand the meaning of the words, “… an accident waiting to happen!” In assessing your possible need for sudden cash infusions, think of yourself as an insurance company underwriter trying to anticipate what could go wrong. Your nickname may be “Tightwad”, referring to the guy or gal driving vehicles that are 10+ years old with more than 100,000 miles. If so, your risk of needing to pay for unexpected repairs, or to confront a sudden situation calling for a vehicle replacement is higher compared to a family driving only late model cars that remain covered by a warranty. If you are a homeowner, your exposure to a variety of repair expenses is decidedly higher than that of a lessee where such exposures belong to the landlord. Either way – tightwad or homeowner – you probably should calculate your cash reserve higher than your counterpart.
  • V – VARIATIONS MATTER. Think about the variability of your cash inflow sources month to month. The leading breadwinner in some families may work in a field where income can be high, but subject to considerable variation on a month-to-month basis. Many positions in sales which pay some component of compensation on commissions are like this. You may calculate that you have a low risk to require cash supplementation on an annual forecast, but find that some months can look much different than others. Just like expenses vary each month, the primary paycheck can vary. Paychecks that are highly variable generally favor a greater emergency cash reserve.
  • E – EARNINGS SOURCES COUNT. Determining an emergency cash reserve starts by comparing predictable expenses to predictable cash sources. Two paychecks mean more flexibility than one. Some households operate on a monthly basis where the take-home paycheck money from one or both contributors is fully spoken for in covering normal bills. In the event of a job loss, there’s clearly a difference in possible need for a cash infusion if one paycheck covers everything compared to the situation where both paychecks are being used. But in either situation, it is fair to say that two-income households can generally tolerate a somewhat lower emergency cash reserve compared to a single-income household.
  • S – SURPLUS COUNTS. Your monthly and annual expected cash generation surplus matters. A household that is regularly saving excess monthly cash flow [over and above pre-tax savings like 401(k) contributions] and adding it to investment accounts may be able to operate on relatively low emergency cash reserves. Why? In the event of unexpected needs, it may be relatively easy to discontinue that savings outflow temporarily, and if required, to even borrow on a short-term basis against investment accounts. When cash flow is restored, repaying such loans in relatively quick fashion from excess monthly cash flows should be relatively painless.

The main take-away: Determining the right emergency reserve for your own situation depends on your unique variables. Imagine the peace of mind that can come from a more deliberate and thoughtful approach to this important area where one size does not fit all.