As a HENRY, there is absolutely no reason why you should not have an adequately funded emergency reserve. Your above average income allows you the bandwidth each month to build and maintain an emergency fund to manage life’s unexpected expenses. Yes, we can get into the nuances of the purpose, size and location of your emergency fund. However, you MUST have an emergency fund and it SHOULD be adequately funded. It does not matter how much money you make; if you cannot handle a large unexpected expense or a sudden job loss as a HENRY, you have a problem. For this reason, I wanted to cover the basics of an emergency fund in today’s post.
The Purpose of an Emergency Fund
Strictly from a utility perspective, an emergency fund serves two core purposes:
- If a large unexpected expense arises, your emergency fund will allow you to cover the expense without interrupting your monthly cashflow, forcing you to go into debt or forcing you to access your long term or retirement savings. Large unexpected expenses could include car repairs or purchases, medical bills, home purchases or repairs, etc.
- In the event of an unexpected job loss, your emergency fund will bridge the gap while you find additional employment. The larger your emergency fund, the longer you can afford to go without accessing long term or retirement savings or going into debt.
Aside from the utility of an emergency fund, there is also the psychological benefit. The psychological benefit can be much more than just having an emergency fund and sleeping well at night knowing you can handle large unexpected expenses. When you have a well funded emergency reserve, you start to get a tase of F-you money. And let me tell you…it tastes good!
The Size of an Emergency Fund
The traditional recommendation is to have 3 – 6 months of expenses in your emergency fund. I think this is a very good baseline for the average person. However, as HENRY, your life likely costs more than the average person because you make an above average income. For this reason, and others which I will discuss below, I recommend an emergency fund of 6 – 12 month of expenses for HENRYs. This in conjunction with after tax investments can really give you options and the psychological benefits can be profound.
When considering the size of your emergency fund, there are several factors you should consider including but not limited to the following:
1. What are your expenses as a percentage of your take-home income?
As discussed in a previous post, a core tenant of financial independence is understanding what your life costs so that you can make conscious decisions to increase your savings in your pursuit of FI. By understanding what your life costs (i.e. your expenses), you will know your expenses as a percentage of your take home income. If you spend 90% of what you take home after taxes, then you have less flexibility each month and likely need a larger emergency fund. If you spend 60% of what you take home after taxes, then you have more flexibility each month and may be able to maintain a smaller emergency fund. Understanding your expenses as a percentage of your take home pay is the first step, and one of the most important.
2. How difficult would it be to find another job?
When determining the size of your emergency fund, you should also consider how difficult it would be to find another job in the event of a job loss. If you lose your job but you are able to find another within 1 – 3 months, then a smaller emergency fund may suffice. However, if you work in a highly specialized role or field, it may take you 6 – 12+ months to find a job and a larger emergency fund is critical.
Many people give thought to their specific job when determining their emergency fund, but there is an often overlooked component that should also be considered. In addition to giving though to how difficult it would be to find a new job, you should also consider how difficult it would be to find THE RIGHT job. The larger your emergency fund, the more options you have and the longer you can afford to wait in your job search. This increased flexibility can have long term financial impacts in the event you ever do lose your job. Let’s consider the following scenarios:
Scenario 1: You have 3 months of living expenses in your emergency fund. You suddenly lose your job where you are making $100K annually. You immediately begin your job search. 2 – 3 months into your search, you have options but the best overall option only pays $75K annually. Since your emergency fund is about to run out, you take the job. In taking the job, you take an immediate 25% pay cut. In addition, each subsequent raise will only serve to bring you back to your original income. Assuming a 5% annual salary increase in your new job, it will take 6 years to get back to you original $100K salary. 6 years! The true opportunity cost is not just your $25K reduction in salary. It is every salary increase thereafter and the lost time associated with investing and allowing that money to work for you. You were forced to settle which in turn has long term negative financial impacts.
Scenario 2: You have 12 months of living expenses in your emergency fund. You suddenly lose your job where you are making $100K annually. You immediately begin your job search. 2 – 3 months into your search, you have options but the best overall option only pays $75K annually. Since your emergency fund still has 9 – 10 months of expenses, you do not take THE job. You continue your search until you are able to find the RIGHT job. In not being forced to settle, you are able to find a new job with a comparable salary. You may even find a job with a higher salary. As a result, you were not forced to settle which in turn has long term positive financial impacts.
3. Are you a single or dual income household?
If you are a dual income household, your two income streams can also give you additional flexibility. If one of you were to lose your job, you would still have one remaining source of income. This arguably allows you to take more risk by maintaining a smaller emergency fund, in turn allowing you to prioritize debt or other investment/savings vehicles. If you are a single income household, the opposite is true. As the sole income source, if you were to lose your job, you have no income to pay your expenses. For this reason, you have less risk capacity and should maintain a larger emergency fund. When considering this aspect, you should also factor in each income relative to your total income and the time required to find each respective job.
4. If you are a dual income household, how correlated are your incomes?
If you are a dual income household, it is important to consider your sources of income and their correlation. The higher degree of correlation, either directly or indirectly, the more risk may be present. If you both work in the same industry, field or market, then your incomes are dependent on many of the same economic factors. Even if you do not work in the same industry, field, or market, there may still be an indirect correlation. A downturn in particular industry or field or a more broad economic downturn or recession may impact you both similarly. The point here is that you should give some thought to each job and the correlation. The more correlated, the more risk. The more risk, the greater the need for a larger emergency fund.
5. What is your risk tolerance?
This is the purely the psychological side of it. Are you someone that takes a lot of risk and can still sleep well at night with a smaller emergency fund? Are you someone that is very risk adverse and must have a larger emergency fund to sleep well at night? Perhaps you don’t know where you fall. Hopefully, by asking yourself some of the questions above, you may have a better feel for your risk tolerance. Everyone is different, and it is a very personal decision.
The Location of an Emergency Fund
I will do a more in-depth post in the future explaining all the nuances of maintaining an emergency fund and how that evolves as you build more wealth. However, I want to keep it simple today. Your emergency fund should be kept in a low risk, liquid, and easy to access financial vehicle. Ideally, it should also be guaranteed/insured.
Common Financial Vehicles
When most people think of an emergency fund, they think of a checking or savings account, certificates of deposit (CDs) or money market accounts. All of these accounts generally carry FDIC insurance up to $250,000. There are rules around insurance coverage based upon types of accounts, ownership, etc. The liquidity and accessibility of these accounts in conjunction with the FDIC insurance make them all excellent options for an emergency fund.
Another popular option is treasury securities including treasury bills (t-bills), notes and bonds. These are not FDIC insured. However, they are backed by the full faith and credit of the US Government which is about as guaranteed as you can get.
Not All Banks are Created Equal
There is another very important factor you should consider when determining where to put your emergency fund. The interest rate.
Interest rates are historically low as of publication of this post in July 2020. The average interest rate nationally on a savings account is .06%. CDs aren’t much better. If you keep your emergency fund in one of the financial vehicles above at your local brick and mortar bank, I argue that you are doing it wrong. Online banks have been around for years and there are many of them. I personally like Ally Bank. Due to their low overhead costs, online banks can offer much more competitive rates on checking and savings accounts, CD’s, etc. Online banks are currently averaging 1% or more on high yield savings accounts. A year and half ago they were averaging 2% or more. They carry the same FDIC insurance that your local brick and mortar bank carries. They have many options that allow them to function like a standard brick and mortar bank (i.e. reimbursed ATM fees, etc.) and they often have much better customer service.
The point here is that not all banks are created equal and you need to consider where you keep your emergency fund. If you have never bothered to understand how online banks work or the difference between a standard checking/saving account vs. a high yield checking/saving account, you are doing yourself a disservice. Inflation is a real thing. The average historic inflation rate is ~ 3%. If you can offset inflation by keeping your emergency fund in a location that earns 1%, 2% or 3%+ interest while still remaining low risk, liquid, and accessible, it is a no brainer.
A Taste of F-You Money
F-you money is a term often referenced in the financial independence space. F-you money is defined as having the necessary money to maintain your desired lifestyle in perpetuity without needing employment or other financial assistance. If you are financially independent, you have F-you money.
However, like most things in life, F-you money is not black and white. F-you money is not finite. I argue that having a well funded emergency fund gives you a taste of F-you money. Think about it. The average employee lives paycheck to paycheck. A job loss would be catastrophic financially. Why be average? You already have an above average income. If you couple that with 12 months of expenses in a low risk, accessible and liquid vehicle(s), you have options that others do not. You are not beholden to your employer and your job. You do not have to be afraid to speak up if you seek change. You do not have to be afraid to present your ideas or challenge the ideas of others. In short, you do not have to live afraid to lose your job. Why? Because you have well funded emergency fund. You have a taste of F-you money.
Regards,
– Henry
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Henry’s Highlight:
Despite my high income as a HENRY, I did not have an adequately funded emergency reserve for years. Some of it was driven by other priorities including debt repayment and excessive spending but much of it was driven by a lack of understanding of the importance of an emergency fund. I now keep a multi-tiered emergency fund of ~ 12 months of expenses spread across 4 separate financial vehicles.
- Checking Account – 1 Month of Expenses
- High Yield Online Bank Savings Account – 2 Months of Expenses
- Online Bank Certificates of Deposit (CDs) – 6 Months of Expenses
- Taxable Brokerage Account (Low Risk Investments) – 3 Months of Expenses
It is important to understand that my approach above is not an absolute. Interest rates continue to fall which is why 6 months of expenses are in CDs whereby I locked in favorable rates some time ago. As I continue my journey to financial independence, my approach to my finances will evolve to include my emergency fund. Personal finance is exactly that…personal. You have to decide what works for you, execute and then make changes as needed. The above works for me until such time it doesn’t.