Savings Framework and Emergency Savings
You may be thinking you’d like to get started with investing. Before doing that, you’ll want to look at how much savings you have and how much you can invest. In this three-part post, I’ll illustrate a framework to guide savings and investing decisions, key components of a financial plan. This post will focus on a very high-level structure for your investable asset portfolio and, specifically, emergency savings. My next post presenst a case study addressing saving for large purchases and retirement. The third post will continue with the case study, focusing on when to accelerate your debt payments.
Case Study
To help set the stage, I’ll create a fictitious person, Mary, whose finances I’ll use for illustration.
Mary's Situation
Mary is single with no dependents.
She lives alone in an apartment she rents.
She makes $62,000 per year.
Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
Her annual budget shows:
Basic living expenses of $40,000
$5,000 for fun and discretionary items
$10,000 for social security, Federal and state income taxes
$4,000 for 401(k) contributions
$3,000 for non-retirement savings
Mary has $15,000 in student loans which have a 5% interest rate.
She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
She has no plans to buy a house in the near future.
Mary's Questions
Mary’s questions are:
Should I start investing the $25,000 in my savings account?
Should I have a separate account to save the $10,000 for the car?
What choices do I have for my first investments for any money I don’t set aside for my car?
Should I pay off some or all of the principal on my student loans?
Investable Asset Portfolio
Investable asset portfolio? Isn’t that something for companies and for the rich? Actually, no. I think about any savings and other invested assets as a portfolio. My husband and I own many other assets, such as our home, our cars and our household goods. Because those are not assets that we can invest, we include them when we are evaluating our net worth but don’t consider them part of our investable asset portfolio. Mary’s investable asset portfolio consists of her savings account and her Roth 401(k).
Within my portfolio, I strive to keep a target amount in very liquid (i.e., easily converted to cash), low risk assets for emergency savings. If I have a large purchase that I want to make soon, such as when we sold our house but knew we were going to buy a new one, I invest that money in slightly less liquid, slightly more risky assets with slightly higher returns. I’ll call these designated savings and talk about the investment I chose in the next post in this series. I then look at the rest of my portfolio in terms of how long until I will need the money, how much return do I want and how much risk I can tolerate, as well as how much time I’m willing to spend researching and monitoring it.
Expenses Paid Less than Monthly
There are some expenses that you pay less often than once a month. Examples include presents (most of us have a relatively large expenditure in December, but also don’t forget birthdays), property taxes if you own a house and insurance. In the months that you don’t have these expenses, you’ll want to set aside enough money so you make these payments when they are due.
Mary has made a list of these expenses from her budget. Specifically, she has budgeted $400 for presents, $1,000 for a vacation and $1,000 for car and renters insurance which she pays once a year. She puts $200 a month into her bank savings account to cover these expenses. When she pays for her insurance or vacation, she transfers the money back to checking.
Emergency Savings
How Much?
Three to six months of basic expenses is considered a good target for emergency savings. To help me estimate how much I need in emergency savings, I imagine what would happen if I couldn’t work for that time period. There are many expenses that will be eliminated, such as income taxes, commute expenses and some others. However, there are also additional expenses, possibly including the full cost of health insurance.[1]
In addition to not being able to work, other uses of emergency savings include unexpected medical expenses, serious illness or death in your close family that requires travel and major repairs to your car or house. It is important to recognize what is an emergency and what is not. For example, a funeral is an emergency, while a wedding is a luxury. Your furnace needing replacement is an emergency. Routine maintenance and even medium-sized repairs to your car or house are not emergencies as they are budget items. An important component of using emergency savings is to modify your budget immediately to start re-building it.
Mary has decided to start with a target of four months of expenses for her emergency savings and plans to build it up using $1,500 a year from her non-retirement savings budget until it reaches six months of expenses. As a first approximation of how much emergency savings Mary needs, she could take a third (four months divided by twelve months in a year) of her salary or just over $20,000. Because Mary has a budget, she can identify those expenses that absolutely necessary. Her budget shows $40,000 of basic living expenses so a third of that would be $13,333. She will use $13,000 as her target for her emergency savings, leaving her with $12,000 for designated and long-term savings.
Where to Invest?
Mary considers only a few choices for her emergency savings - including her bank savings accounts, a high-yield checking or savings account at a brokerage firm and a money market account.
A Bit about Money Market Accounts
Money market accounts tend to return a slightly higher yield than savings accounts. They are like other securities in that you have to buy and sell them, but you can often have access to your money in 24 hours (as compared to instantly for a savings account).Money market accounts also have slightly more risk than savings accounts. Many money market funds buy very safe securities, such as certificates of deposit and US government bonds so have very little risk. Others take more risk by investing in commercial paper which is essentially a short-term loan for a company. In 2008, the value of a few money market funds backed by commercial paper fell below $1.00. When the value of a money market fund falls below $1.00, it is called “breaking the dollar,” For emergency savings, you’ll want to focus on funds backed by US government debt securities.
Money market accounts from a bank are insured by the Federal Deposit Insurance Corporation, while those at brokerage firms are not. Money market funds at brokerage houses are insured by the US Treasury if the brokerage firm fails but not if the fund breaks the dollar. If the value of the investments purchased by the money market fund fall in value, the value of your principal might decrease. I am not aware of any money market funds that have lost value. There are some money market funds that invest in higher risk instruments.
For emergency savings, Mary will consider only money market funds that buy low-risk instruments. You might be thinking I’m kidding. Keep some money in a savings account! You might be excited to participate in the seemingly glamorous world of trading stocks and other financial instruments. Unfortunately, those financial instruments are risky. That is, you might lose some of the money you invest in those instruments if their value goes down. (I have a lot to say about risk and reward in this post.)
Back to Mary's Emergency Savings
Because emergency savings are meant to be available on a moment’s notice at their full value, Mary will keep hers in those two very boring places – a savings account and a money market account.At one brokerage firm, high-yield checking and savings accounts are earning 0.35% to 0.45% as I write this post. US government-backed money market accounts are earning as much as 1.9%[2] or about 1.5 percentage points higher than the checking and savings accounts. (The money market rate at one bank is 1.87% or essentially the same as the brokerage firm.)
Mary decides to put half of her emergency savings in a high-yield checking account so she is sure to have instant access to it and half in a money market account. This decision gives her an average return of 1.275%, as compared to the 0.06%[3]she was earning on her bank’s savings account. So, while the savings account and a money market account are not as exciting as buying stocks, she can improve her return as compared to her bank’s savings account.
In the next post in this series, I’ll talk about how Mary plans to invest her designated savings and long-term savings. I promise – the choices get a bit less boring.
Key Points
The key takeaways from this case study are:
There are different purposes for savings – expenses you don’t pay every month, emergencies, large future purchases and long-term.
Expenses paid less than monthly can be budgeted and set aside in a very safe, easily accessed place, such as a savings account, until needed.
Emergency savings of three to six months of basic living expenses is a good target. If you have lots of back-up options – financially supportive parents or relatives, another place nearby you could live for a few months in an emergency or the like, your target can be at the low end of the range. On the other hand, if you are like one friend of mine whose family lives in Europe while he lives in the US so an emergency trip home would be very expensive or you don’t have many back-up options, you might want to set the high end of the range as your ultimate target.
It is important to replace emergency savings as quickly as possible after using them.
A portion of emergency savings (the greater of one month’s expenses or travel expenses to immediate family) should be available at any time; while a portion can be invested in something that takes a day or two to access.
Your Next Steps
This post talks about Mary’s situation. Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.
Make a budget. A budget will help you understand your financial situations. For help with budgeting, check out my series of posts with a step-by-step plan for building a budget, starting with this one.
Identify the expenses in your budget that you pay less than once a month. Determine how much you need to set aside each month to cover them. In each month, you will increase this component of your savings by 1/12th of the total amount of less-than-monthly expense. You will also reduce it by any of these expenses that need to be paid in the month.
Do you want to start a relationship with a brokerage firm? If so, here are some questions to consider:
What types of accounts does it offer?
What are the fees and limitations associated with those accounts?
What are the returns it is offering on those accounts?
Can you access those accounts using an ATM card, electronic banking or checks? What are the fees associated with them? My brokerage firm waives all ATM card fees which is great in an emergency because I can get cash anywhere in the world.
Do you want to be able to meet with someone in person? This question was critical for me. While I probably use e-mail more than I should, I need to be able to go into the office for big transactions and, to a lesser extent, advice. If you are like me in that regard, particularly if you are looking for advice, you’ll want a brokerage firm with a conveniently-located office and a team you can trust.
Set an emergency savings target.
Look into options for your emergency savings.
Does your bank or, if you have one, brokerage firm, offer high-yield checking or savings accounts? What are the fees and limitations on those accounts? An account with a large minimum balance isn’t attractive for emergency savings because you might need to empty it on short notice.
Do you want to consider a money market account for some of your emergency savings? If so, what options are offered by your bank and brokerage firm? What returns are being offered? How long will it take to access your money? How easy is it to access the money, such as by transferring it to your checking account? In an emergency, you probably won’t want to feel overwhelmed by the process of accessing your emergency funds..
[1]For a longer discussion of emergency savings, check out http://brokewallet.com/emergency-fund/.
[2]https://www.schwab.com/public/schwab/investing/accounts_products/investment/money_markets_funds/purchased_money_funds#government_treasury, December 2, 2018.
[3]https://www.wellsfargo.com/savings-cds/rates, November 17, 2018.
