The economic downturn has brought finances and the need for planning into the headlines. As people consider the reality of job loss, the concept of having a rainy day fund evolves from proverb to reality. Having some easily accessible savings to cover an emergency is generally a good idea but it may not be easy to decide how much to set aside. One of the main reasons this is true is because saving money is always accompanied by an opportunity cost. That is, if people are building up their savings, they are not doing something else with their money. For example, if they’re not funding their retirement account, they may be trading one problem for another.
Since prudent planning generally includes having emergency funds available, we must decide how much is enough. I have often heard “six months spending” suggested as a target but I have found that to be a frustrating goal for many. When a target amount seems too imposing, some people will see no way to reach it and simply quit trying. Before he retired from the Wall Street Journal, Jonathan Clements once wrote that people with equity in their homes didn’t need such a fund as they could always borrow via a second mortgage. I believe he later retracted that statement but I think it might be a concept worth considering. Even though home equity was sometimes poorly used leading-up to the recent market meltdown, I think planning on utilizing a second mortgage remains a sensible option for many.
Such available equity allows the necessary savings to be smaller, so the correct amount might be the answer to the question: “How much do you want to be able to tap without having to borrow?” When I work with individual clients, I often suggest a range of things, not dollars. I.e., do you want to be able to have your car’s transmission repaired or buy a refrigerator or re-roof the house? I think people are often better at answering thing questions because not everyone still thinks in terms of costs these days. Over the years, many have gotten more used to payments instead.
This approach usually allows us to arrive at an appropriate size for the fund, bringing us back to the question of the best way to build it. If we choose to do so over time, some sustainable amount must be named. Rather than offer a suggestion like reducing your latte intake by 2 per week and using that $10 to fund the account, I think a more useful approach is to consider Nike’s slogan: Just Do It. The target balance can be divided by 52 to yield the amount to be saved weekly. If you pay yourself first, you will adjust your budget around those extra savings. When time doesn’t appear to be an issue, it may be easier to start with something like half of the next raise or a lump sum like a portion of a tax refund.
Once the funding is completed, of course, a decision must be made about what to do with that extra money. As planners, we are likely to suggest that the saving be continued and added to college or retirement savings.
With as many different situations as clients, no one answer is ever going to suffice for all. We work with each client trying to guide the process, usually starting with a short test aimed at learning about each one’s tolerance for risk. Depending on the situation, we might also employ additional tests which help us discover the role money plays in a person’s life. These tools allow us to learn enough to make appropriate suggestions for each question. Once a “rainy day fund” is established, it has been our experience that saving very often becomes a self-fulfilling prophecy: when people see the account growing, it’s reinforcing. They become more wedded to the idea, eventually ensuring their saving success.
Warren Ward Associates does not have the answers to all financial questions, although we almost always have suggestions for our clients to consider. Whether related to developing an emergency fund or deciding how to meet a long-term goal, we are always willing to listen and offer advice.
