Regardless of your personal circumstances, having some of your assets in a readily-available reserve is prudent planning. No one can predict the future, so it’s best to plan in case of emergency or market downturn.
So what are your options for an emergency fund? What about for a liquidity reserve? And how do the two differ? Let’s break it down according to your lifestyle stage.
For clients who are actively employed and earning income, we recommend holding an emergency fund that can cover 6 to 12 months of living expenses.
Those who are retired or preparing to retire have different considerations, but the idea of having a reserve remains important.
EMPLOYED AND SAVING TO YOUR PORTFOLIO
When you are still in the workforce and earning an income, the purpose of an emergency fund is to provide a ready source of cash that can be drawn upon when the unexpected occurs. This may be a temporary disability, job loss, or even the need to provide financial help to a family member.
This is not a fund for you to use for travel or other plans, as important as such plans may be to your well being.
The first objective for your emergency fund is that the funds are readily available when needed (such funds are “liquid,” meaning they are easily converted to cash).
For this reason, unless your reserve is substantial, limit any restrictions that might be imposed on the access to these funds.
Bank savings or money market accounts are often the most commonly used vehicles for emergency funds. Savings certificates with a fixed maturity date and specified fixed interest rate, known as certificates of deposit and commonly referred to as CDs, can serve in an emergency fund, but note that CDs should be of very short duration (1 to 3 months) so as not to impair liquidity when funds are needed.
DRAWING ON YOUR PORTFOLIO
For those clients drawing on their portfolio to help fund their living expenses, a key consideration becomes cash flow. An important component should be considering how you will draw out your needed cash flow when markets are declining—including contingency planning for possible extended declines; for example, the market downturn occurring between 2007 and 2009. We advocate establishing a liquid reserve.
Like an emergency fund, a liquid reserve is a pool of money that can be drawn upon. However, it is for use during a market decline (not a personal emergency).
When market declines persist and the level of decline crosses a predetermined threshold, this triggers the decision to discontinue “regular” portfolio withdrawals, and to begin drawing on the liquid reserve. The objective is to limit the demands on your portfolio investments when the portfolio is under greatest stress (such as the stress arising from falling equity markets).
We typically recommend that a liquid reserve fund 18 to 24 months of needed income. Client circumstances may allow for a greater or lesser target.
In all cases, as with clients funding an emergency reserve, the first objective of this reserve is that these funds will be available (liquid) when needed.
WHERE TO KEEP YOUR EMERGENCY FUND
Subject to the size of your reserve and the time horizon over which these funds may be withdrawn, options for your reserve funds can range from CDs or short-term Treasury Bills to “ultra-short term” bond funds. Each of these can have advantages and some combination may be the best solution.
Where an ultra-short term bond fund is considered, it is important to understand that unlike a savings account that cannot lose principal, a bond fund, even an ultra-short fund, can decline in value in a volatile rising interest rate environment. Our past experience suggests that these funds can recover fairly quickly, but a short term decline can certainly be experienced. While ultra-short funds have historically offered better yields than bank instruments, today, these funds are not necessarily offering notably better yields than may be available through some FDIC-insured vehicles.
Despite the current low yield environment, for some folks, a bank savings or money market account may be best. For those willing to shop around, particularly if you’re willing to work with an online bank, you can find savings account return rates above 1% (significantly better than the average bank savings account).