Emergency Savings Strategy

By Andrea Coombes, MarketWatch:

Are you brave enough to hold your emergency savings in an investment portfolio of stocks and bonds? While some studies suggest it can be a better deal for your finances, plenty of financial planners — and their clients — say it’s a no-go.

Ironically, with interest rates at rock-bottom lows, some might argue it takes more courage to stash savings in a bank account that’s losing money to inflation than to invest it in the volatile stock market.

One recent study found that investing emergency savings in a portfolio of 60% stocks and 40% bonds rather than in cash led to a better outcome — more money at retirement — even after financial shocks like a job loss.

“The traditional recommendation of a cash-only reserve emergency fund strategy is likely to reduce wealth over a lifetime,” the study’s authors said. Read the full study in the Journal of Financial Planning.

“Clients with a high-risk tolerance could consider an aggressive strategy of minimizing cash reserves and maximizing account holdings in an effort to accumulate assets faster, thereby providing funds for emergencies, retirement and future needs,” they wrote.

Of course, our behavior isn’t always rational, and financial advisers say their clients often are not interested in subjecting their savings stash to market risk.

“I think of risk tolerance as having two sides. There’s the financial side: can you afford to invest this money in something risky? And the emotional side: can you tolerate investing in something risky?” said Mike Piper, a
CPA and author of “The Oblivious Investor” blog, based in St. Louis, Mo.

“If you’re going to lose sleep at night, then you can’t afford to do that even if you can financially afford it,” he said.

One very real and worrisome prospect is that you may be forced to sell your holdings when they’re down. 

“If you need the cash, you may end up selling at a very bad time,” said Kevin O’Reilly, a certified financial planner with Foothills Financial Planning in Phoenix

Picture a self-employed consultant whose jobs dry up. He has a three-month savings cushion sitting in cash and another three months in a stock index fund. When his cash cushion runs out, he’s forced to tap his investments — but in that six-month period, the market drops 20%.

“You don’t want to be selling out of that index fund at that time,” O’Reilly said. “Having that cushion protects you. That cash allows you to ride through that drop.”

Even if you don’t need the money for an emergency, watching the market’s gyrations decimate your savings could be painful. “There’s the additional stress even if they don’t need the money,” he said.

Search for yield

While O’Reilly said he’s generally opposed to investing emergency savings in the markets, he also said many people aren’t doing enough to earn a return on savings.

“Most individuals are not maximizing the safe returns that they can get on their emergency funds,” he said. “I typically recommend pulling these funds from the big bank on the corner that pays .01%, and putting them in an FDIC-insured account at an online bank that pays closer to 1%.”

Plenty of financial advisers agree that, opportunity cost or no, emergency savings should stay in a cash-like account.

“I don’t advocate taking on substantial risk with money that is truly earmarked for potential emergencies,” said Rebecca Kennedy, founder and principal of Kennedy Financial Planning in Denver

“But it can be prudent in certain circumstances to invest a portion of one’s reserves into a slightly less liquid, higher-earning vehicle,” she said. Those investment options include laddering CDs with varying maturities, buying I-bonds (which earn an interest rate partly tied to variable inflation rate), or investing in a no-load, low-cost, short-term bond fund.

Of course, all investments come with some type of risk. Short-term bond funds can lose money — and did last year, Kennedy notes, and CDs levy surrender charges.

These types of investment options for emergency savings are not suitable for everyone, she said, only for those who have more than six months’ worth of emergency savings, or a very stable employment situation.

“People with ready access to a low-interest line of credit can also afford to take on a little more risk with their cash reserves since the line of credit can serve as a backup when needed,” she said.

But, she warned, “The danger of relying on the line of credit is that the bank can change its mind about making those funds available to the borrower. I would not use this strategy with someone who lives closer to the edge in terms of their financial stability or has lower emergency reserves.”

If the low rates you’re earning on your savings have got you down, think of the earnings you’re sacrificing as an insurance payment.

“I view the lost opportunity as an insurance cost,” O’Reilly said. “The return I’m not earning on the funds I’ve set aside is like an insurance premium that I pay to protect my other growth assets from being sold at the wrong time.”

Rethink the question

Perhaps a better strategy than subjecting your emergency savings to stock-market risk is to ask yourself how much emergency savings you need, and then invest whatever you have over and above that amount.

Take a dual-income couple, O’Reilly said. “Their need for an emergency fund is probably lower than a single-income couple. They could have a smaller emergency fund, and so the remaining funds can be invested a little more broadly.”

Similarly, your job type plays a part in how big a reserve you need. “If you have a very stable job, for instance a government job or a tenured professor, then you can certainly get away with a much lower emergency fund,” Piper said.

Piper, who is self-employed, said he keeps one year’s worth of living expenses in cash or cash-like investments. “I don’t think there’s a one-size-fits-all rule. It varies depending on what type of emergency you can be exposed to, with job loss being the biggest one.”

O’Reilly said the range for his clients is three to 12 months. “The rules of thumb that applied seven or eight years ago might not be quite the same now because people take longer to get new jobs,” he said. “It depends on what you do. If you’re tenured, you’re pretty safe. If you’re working in high tech or you’re an engineer, there might be a little more demand for those roles — even if there’s a job interruption, you might expect that to be briefer.”

Meanwhile, Brett Horowitz, a vice president and wealth manager with Evensky & Katz in Coral Gables, Fla., said the firm advises its retiree clients to stash one to two years’ worth of expenses in savings. Clients feel a lot better, he said, when a year like 2009 comes around “and they can look down at their checking account and see $100,000 sitting there.”

When stocks go down 20%, they don’t need to worry about selling anything to cover their bills. “The psychology, for us, is maybe the biggest aspect of it,” Horowitz said.

“The purpose of that emergency reserve is for emergencies,” he said. “You’re giving up the opportunity cost but you have the safety blanket there in case you need it.”

Another viewpoint

There’s another psychological point to consider, said Sheryl Garrett, founder of the Garrett Planning Network, a network of fee-only financial advisers.

If you’re liable to reach into emergency savings even when it’s not a true emergency, then an investment vehicle might be better for you. Garrett said investing her savings afforded her a sense of discipline when she was in her 20s and all-to-likely to spend what was in her bank account.

“Something had to be truly an emergency for me to pillage my investment account,” she said. “I’ve recommended it to some clients, not everybody, but for those people who lack the discipline, like I used to.”
Meanwhile, the blogger known as Mr. Money Mustache said he invests his emergency savings without a problem. Here’s what he said during a recent interview with MarketWatch:

“I’ve always questioned the idea of an emergency fund. It’s a great tool for the financial beginner who lives from paycheck to paycheck, and for whom a broken water heater would make the difference between making ends meet and borrowing via a credit card. But once you get off the ground, your credit card is a monthly buffer and your investment accounts are the emergency fund,” he said.

Don’t forget your Roth

For many Americans, the many competing demands on their money — monthly bills, debt payments and retirement and college savings goals — can make it difficult to create a sufficient rainy day fund.

If that describes your situation, then consider this: A Roth IRA can act as an emergency fund, with some caveats.

“If someone has, say, $5,000 they think could be emergency fund money or retirement savings money, there’s not a lot of downside to contributing it to a Roth, as long as you keep it in something safe,” Piper said.

That’s because any contributions you make to a Roth are always available to you, free of taxes and penalty. There are some caveats: Unless you meet certain rules, only the money that you contributed is available free of penalties and taxes. Any earnings on your money, and any money that you converted from a traditional IRA could be hit with a big penalty and income taxes.

“All the various hoops that you need to jump through only apply to earnings that have happened in the account or to amounts that are in the account as a result of a Roth conversion,” Piper said.

Also, Roth 401(k)s don’t offer the same freedom as Roth IRAs. You can’t withdraw your contributions while you work at that employer, Piper said.

Plus, if you’re in the right tax bracket, you might qualify for the retirement saver’s credit.

But, Piper warns, if this Roth contribution is doubling as emergency savings, then don’t invest it in the stock market. “If this is money that you might want to use in the event of an emergency, you would want to keep it in something safe. You can own CDs with an IRA, or low-risk bonds or any number of other investments.”