Emergency Fund Strategy

[BeamOn]

I wanted to get some thoughts from the group on emergency fund structure/scheme. I had set things up as a 6 month minimum living expenses fund earning 1% in a high yield online savings account. We are currently spending about 25% of net income with the rest maxing out tax advantaged retirement accounts and biting away at huge student loans.

It feels wasteful to have 6 months of expenses earning below inflation when even refinanced student loans are closer to 2.9%. Does anyone carry muni bonds or something similarly low risk in a taxable account as part of a de-facto emergency fund? How about higher risk/return investments like market ETFs? If so how much cash reserve vs less liquid backup do you keep? Thanks!

[jz]

 

I agree 6 months of expenses earning below inflation is wasteful;  yet if you lost your employment or became disabled, you'd need preserved principal.

I use  short-term muni bond fund , series I bonds, higher yield CD ladder. The penalties for premature redemption are small.  The highest yield CDs , from online Ally and Synchrony Bank,  yield more than 5 year treasuries. The yield on CDs is highly variable, because the professional class doesn't buy them.  They are used by us retail investors only;  thus the variability in rates is huge.

 

[jfoxcpacfp]

In the short term (defined as less than 5 years), security and liquidity should be prioritized over earnings. A muni bond fund is not a good choice as there is no guarantee you will get your principle returned. For an emergency fund, just find the highest earning liquid money market account (not money market fund) and stick your savings there. A CD is not appropriate if you do not have a time-specific goal (ex: car replacement in 3 years) as you will have to pay a penalty if you cash in before due. We typically use high-quality corporate bonds timed to date of need in those circumstances.

[jz]

I strongly disagree with jfox view of  short term munis.

Looking at Vanguard's Limited Term Muni Fund ( VMLUX ), duration 1-3 years,   the WORST  draw down of the past 10 years , was 5%.  The 2013 draw down , after Detroit and Puerto Rico bankruptcies, was 1%.   The key is to stay SHORT term.  Those are minuscule risks of principal  to pay for immediate liquidity when you unexpectedly need it, meanwhile  earning small after tax returns of ( currently ) 1%.

I strongly disagree with jfox view of CDs. She shifted the goal post from -an unexpected emergency to -a planned purchase.

 

 

 

[Zaphod]

I do muni bond funds as my emergency and even put my taxes in there as the year goes by to gain what turns out to be a large spread on the penalty. They also pay monthly so compounding is more even as you catch more swings vs. 2 or 4 times a year. I have funds of varying duration, and am not necessarily as worried about large draw downs, as the likelihood you'll ever need 100% of your funds is low, and that it will coincide with a drawdown and stay there, is even lower. The best part about this is the base grows over time and even a serious drawdown wont touch your principal.

Even vanguards intermediate termed bonds that yield somewhere around 3 percent only had a draw down of 7.27% during the recession. Thats nothing, and it wasnt permanent. All my funds are up ytd even, they are less volatile. Even then, you could simply and arguably is wise to set some trailing limit stop losses at your minimum necessity numbers. Also have to remember that you need to apply the tax equivalent yield to your yield to see what you would have to get to equal that funds return, its very interesting.

Here is a cool calculator that will show it to you: http://funds.eatonvance.com/tax-equivalent-yield-calculator.php

[jfoxcpacfp]

jz wrote:

I strongly disagree with jfox view of  short term munis.

Looking at Vanguard’s Limited Term Muni Fund ( VMLUX ), duration 1-3 years,   the WORST  draw down of the past 10 years , was 5%.  The 2013 draw down , after Detroit and Puerto Rico bankruptcies, was 1%.   The key is to stay SHORT term.  Those are minuscule risks of principal  to pay for immediate liquidity when you unexpectedly need it, meanwhile  earning small after tax returns of ( currently ) 1%.

I strongly disagree with jfox view of CDs. She shifted the goal post from -an unexpected emergency to -a planned purchase.

 

 

 

Click to expand...

By definition, an emergency cannot be timed. So, you are telling me that, in the last 5 years, NO muni bond fund has dipped below cost? Of course not, according to your own statements. The purpose of emergency funds is to have liquid safe funds available when you need them, not speculate that you'll be able to sell at a gain.

As for CD's, you brought them into the conversation. And you are telling me that you used laddered CDs for an unplanned emergency? Are you sure you're not mixing "emergencies" with "planned short-term goals"? I would agree with using them for short-term goals.

[jz]

jfox,

I'm citing data; ie. maximal draw downs of 5%/ 5 years.

You are reverting to an all/nothing argument. Please be more nuanced in your thinking , considering the audience here.

Penalties for premature CD redemption are typically 3 months of interest.  Again, this is trivial.

 

[jfoxcpacfp]

jz wrote:

jfox,

I’m citing data; ie. maximal draw downs of 5%/ 5 years.

You are reverting to an all/nothing argument. Please be more nuanced in your thinking , considering the audience here.

Penalties for premature CD redemption are typically 3 months of interest.  Again, this is trivial.

 

Click to expand...

It depends how you define emergency fund needs. 6 months of living expenses was how the original post began and, you're correct, I took that at face value. I think each person has to determine what their emergency fund would be used for, i.e. what circumstances would lead to dipping into it and would it be an issue if you have to liquidate when a fund has dropped in value. My point is simply that we should not let the earnings tail wag the dog. An emergency fund, imho, should be there when you need it. As for the penalties, I agree that a lot of the amounts are trivial when looking at what you may or may not earn or lose on an emergency fund. My rule of thumb, for clients at least, is to get the highest return possible after first securing the money in a secure and liquid vehicle. It's the opposite for long term investing.

[The White Coat Investor]

The point of an emergency fund isn't to earn money on the fund. Think of it as an insurance policy-the insurance costs something. In this case, that's low returns. Sure, you can take some risk with your emergency fund and hope to get a little more return out of it, but the more risk you take, the less insurance you get. If you really feel a need to invest that money in something higher returning, perhaps your e-fund is too large. You can also have "tiers" of emergency money. Some in your checking account, some more in a savings account, and some more in a short term bond index or CDs or I bonds perhaps.

My emergency money, at least what isn't in cash at the house and in the checking account, sits with my short term savings in an utterly misnamed "high-yield" savings account at Ally Bank paying 1%.

The insurance policy allows you to invest the rest of your portfolio aggressively without having to worry that you might need it for short term needs.

[nyu04]

The White Coat Investor wrote:

My emergency money, at least what isn’t in cash at the house and in the checking account, sits with my short term savings in an utterly misnamed “high-yield” savings account at Ally Bank paying 1%.

Click to expand...

This is what we do as well.

[Bartl007]

Just some food for thought. Basically take 130% of what you think you need and invest it in a typical stock/bond portfolio


https://www.betterment.com/resources/personal-finance/safety-net-funds-why-traditional-advice-is-wrong/

No financial disclosures or conflicts but I'm interested in what others are doing when the likelihood of ever tapping into these funds is low (for the majority of WCI readers)

[TheGipper]

Many young physicians have large emergency funds due to large estimated 6 month expenses (high student loans, jumbo mortgage on that big house, daycare costs if spouse works, etc...)

To me that betterment article names a lot of sense. Why not invest $100k in tax efficient total market index funds and muni bond funds in whatever AA you feel comfortable with to the tune of 140% of a low yielding emergency fund in cash, checking, CDs, online savings, or I bonds.

Chance of needing it is low, if you do chance of needing it during a bear market is lower. Sure you'll pay some cap gains tax, but over 20-30 years you'll almost certainly be better off and just as well insured.

[Jenn]

I ladder CDs over several years- some of them as far off as college or possible weddings for the kids- and recycle if not needed. Have one maturing q2-3 months, each one covering 1-2 months barebone expenses, and for larger needs could pay early closure penalty. "Borrowing" from the one that just matured, rather than cycling it forward, to loan our kid some money. (If she never pays us back that'll come out of her wedding fund.)

[Zaphod]

Agree with the 130-150% ideas. If you think about it using probabilities, the likelihood you ever need it as it is typically thought of is low, very low. The much higher likelihood is it becomes a drag. As you start to self insure and on to the path of FI you should be able to decrease the size or amount exposed to simply a savings account as well. Isnt this why we carry other types of insurance as well? There is certainly room for nuance in this area. How long will it take on average before an invested amount is well above your emergency needs anyway? Not that long, and it will just be extra cushion if needed.

It would need to be a thoughtful portfolio of course, designed for limited volatility and such. I wouldnt recommend a biotech tilt or leveraged crude oil fund of course, but a portfolio with a mix of broad stocks and bonds is good.

[The White Coat Investor]

Zaphod wrote:

Agree with the 130-150% ideas. If you think about it using probabilities, the likelihood you ever need it as it is typically thought of is low, very low. The much higher likelihood is it becomes a drag. As you start to self insure and on to the path of FI you should be able to decrease the size or amount exposed to simply a savings account as well. Isnt this why we carry other types of insurance as well? There is certainly room for nuance in this area. How long will it take on average before an invested amount is well above your emergency needs anyway? Not that long, and it will just be extra cushion if needed.

It would need to be a thoughtful portfolio of course, designed for limited volatility and such. I wouldnt recommend a biotech tilt or leveraged crude oil fund of course, but a portfolio with a mix of broad stocks and bonds is good.

Click to expand...

I think your point is that a retiree doesn't need an e-fund. The entire portfolio is the e-fund. At some point in a successful earning/saving/investing career you no longer need an e-fund. I mean, I have one, but I also have enough money invested at this point that I could support my family for a decade or two without too much difficulty. Not yet "enough" but getting awfully close.