By Keith Whitcomb, RMA
The COVID-19 pandemic has painfully demonstrated to the 20 million people who lost their jobs in April why it is important to prepare for unexpected financial events. Add in a Federal Reserve study many have claimed shows that 40% of Americans don’t have enough money to cover a $400 unplanned expenditure, and it is not surprising that there recently has been a renewed interest in emergency funds. While likely taken out of context, i.e., only 12% actually stated they couldn’t pay the $400, perhaps a more interesting byproduct of the Fed’s report was the following range of non-cash payment options they suggested in their survey:
· Put it on my credit card and pay it off in full at the next statement or over time
· Use money from a bank loan or line of credit
· Borrow from a friend or family member
· Use a payday loan, deposit advance, or overdraft
· Sell something
The implication is that there are multiple ways to marshal financial resources to pay for emergencies. So, do you really need a stash of cash to cover three to six-months of household expenses as recommended by the experts, or are there other/better alternatives? Let’s take a look.
First off, let’s define what qualifies as an emergency. For this article, it is a sudden, unusual, and major financial setback that results in your inability to pay for non-discretionary expenses. It can be the result of a loss of income (e.g. job disruption), an increase in expenses (e.g. medical bills), or a combination of both. These events are rare, potentially occurring only once in a lifetime, and are short-term in nature, likely being resolved within six months.
What’s wrong with cash?
While putting cash in a bank account is widely considered to be one of the best ways to prepare for an emergency (it’s liquid, shielded from market volatility, FDIC insured, and easily accessible), it isn’t perfect. Here are a few drawbacks:
Opportunity Cost – While using a 401(k) loan in a financial emergency is often discouraged because it can reduce investments earning market-based returns, maintaining a permanent layer of low-performing cash in a taxable bank account to pay for an emergency that may never materialize will likely lead to even greater investment under-performance.
Lack of Discipline – Easy access to a bank account is a two-edged sword. While it is perfect for making payments during a crisis, it’s also susceptible to non-emergency withdrawals. Having ATM-available cash may be one reason why 45% of respondents had $0 in savings according to a Statista 2019 survey.
Over Specialization – Based on your individual financial circumstances, you may find it structurally impractical, i.e. restrictions and penalties regarding withdrawals and utilization, to use a compartmentalized asset accumulation strategy that includes a cash emergency fund, 401(k), 529 college savings account, FSA, HSA, IRA, and so on. Inefficiencies can arise when your money is spread out in a number of limited access locations, in particular if it forces you to use more costly alternatives in a time of need.
In response to COVID-19, Congress enacted the CARES Act which eliminated 401(k) withdrawal penalties (for a limited time only). Like so many other things that have experienced accelerated change as a result of the coronavirus, perhaps this legislation is a harbinger of an expanded view on the role of retirement savings.
Should you take advantage of accounts that have multiple purposes like providing liquidity during times of financial stress? Absolutely. When resources are limited, understanding all the attributes of an account location and utilizing them is the name of the game. In essence, you need to move from an attitude of owning many single purpose specialized savings vehicles to a view of “driving” multi-purpose “sports utility” savings vehicles.
Consider a Health Savings Account (HSA). The HSA can be used to pay current medical expenses, accumulate money for future medical expenses, and in retirement pay for non-medical expenses being subject only to ordinary income tax. All of these features should be incorporated into your financial plans.
Emergency Fund versus Emergency Funding
Even without a designated emergency fund, most people have some form of emergency funding. Going back to the Fed’s survey, using cash is only one of many ways to pay for a financial emergency. Alternatives also include “social” capital, insurance, other assets, and credit. The idea here is to evaluate your entire financial safety net to understand product/service options, limitations, costs, and benefits. Here are some examples:
Social Capital – Social capital is defined here as institutional support. Government programs like unemployment and disability insurance are familiar examples. Employer-paid benefits can also be viewed as a “social” safety net. Offerings typically include short-term disability insurance, term life insurance, and employee assistance programs. Finally, corporate “social” benevolence like restructuring debt or renegotiating hospital expenses are two additional examples.
Insurance – Instead of “coverage” think of insurance as emergency funding. In some ways, it’s the ultimate emergency funding vehicle. By design, insurance contracts have a defined premium and a payout schedule for specific and potentially financially disastrous exposures. This can make it a very cost-effective solution. The next time you go through open enrollment, check out the pricing and features of any supplemental policies offered through your employer (e.g. disability, life, health, and more).
Assets – COVID-19 highlighted the risk of a down market during an emergency, i.e., loss of job and/or increased healthcare expenses, so understanding asset liquidity and volatility is important. At this point we have already looked at cash, so let’s evaluate other assets.
While taxable brokerage accounts are accessible, those filled with long-term growth-oriented assets were not suitable for use earlier this year given the market decline. A CD on the other hand has reliable returns, but untimely early withdrawals can result in penalties. A Roth account is a multi-task asset option (long-term savings, tax free growth, penalty free withdrawals of contributions) with the potential for better performance than a CD or cash/money market account. However, a portion may need to be conservatively invested to guard against market under-performance. This doesn’t mean that these or other similar investments are inappropriate, only that their underlying characteristics need to be taken into consideration when creating your plan.
Credit – Unused and available credit is another source of funding. You can borrow from yourself with a 401(k) loan or the cash value of a life insurance policy, leverage the equity in your home with a HELOC or HECM, or turn to more traditional sources like credit cards and personal loans. While not included on a balance sheet (until actually used), building standby borrowing capacity is something you should consider when developing emergency funding alternatives. The downside here is that the availability of credit may be subject to limitations and circumstances beyond your control like these:
o Home values and as a result home equity lines can fluctuate
o Your credit rating may fall, potentially as a result of a financial emergency
o Job loss will likely negatively impact your ability to borrow from a 401(k)
o Borrowing the cash value of life insurance can lead to a lapse of the policy and taxes
These or other issues may outweigh the benefits associated with using debt during an emergency.
The danger is that this funding will actually be unavailable the moment you need it. As a result, it is critical that you understand the specific terms and conditions of each of these options.
Another drawback to borrowing is that you have to pay interest. However, if the interest expense is compared to the costs of other alternatives (i.e. opportunity cost of cash and premium payments for insurance), debt may actually be cheaper because you only incur this expense when you borrow the money. With cash in bank and insurance, the cost is ongoing, regardless of utilization.
Your Action Plan
When my sister lived in Clairemont California, I happened to look up the town’s emergency action plan (EAP). It addressed earth quakes, floods, landslides, and wildfires. In one scenario, if a dam ruptured (which was basically built in a fault zone), it was estimated that my sister would have 15 minutes to evacuate before an eight-foot wall of water would destroy her home. But there was a plan for that.
In a similar way, you need a personalized emergency action plan. It will specifically document a list of exposures and associated utilization strategies of social capital, insurance, assets, and debt to address each crisis. Finally, in addition to the initial creation of your EAP, you will also need to periodically revisit it to adjust and continuously improve the plan as your life circumstances change over time.
About the author – Keith Whitcomb
Keith Whitcomb, MBA, RMA®, is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.