Having emergency savings fund is personal finance 101. We hold 3 months’ expenses, which is on the low side. The conventional wisdom is to have between 3 and 6 months’ wages in cash. So, why is my number so low?
Why you should have an emergency fund
Most people would assume that an “emergency fund” is there to cover actual emergencies. This is technically correct. However, for financial independence campaigners, these emergencies might be a bit different (and more luxurious) than you were taught about in school.
When disaster strikes – the boiler explodes, you get made redundant, that kind of thing – you have a few options to pay to fix things. These could be:
- Pay in cash from your wages/earnings and tighten your belt this month. You didn’t need to see your friends this month, right? Beans on toast for tea again!
- Use a 0% credit card offer. Future you can take one for the team…
- Take out a loan or overdraft. Enjoy having compound interest working against you.
- Sell some assets like those shares you wanted to fund your retirement. Or, you could just…
- Pay in cash savings that you had in an emergency fund!
Murphy’s Law (Sod’s Lore?) says that anything that can go wrong, will go wrong. Maybe I’m a pessimist, but the one time you need that cash to hand, it’s December and you’re about to ruin Christmas, your credit card interest is about to jump to 20% APR and your shares are temporarily cheap due to trade war/ pandemic/ a boat trying to Austin Powers reverse in the Suez Canal. Simply put, the costs of the simple boiler replacement will be made a lot worse due to bad timing.
The only option on that list that’s immune to the temporary whims of fate then is having an emergency savings fund in cash.
Wait, you said that it’s different for financial independence campaigners?
If you’re on the financial independence campaign trail, you’re better off than most! Chances are that you’re getting or already are debt free. You probably have a few assets, like property or shares in ETFs. If you’re very advanced and you’re already financially independent, you might be living on these assets. This gives you three potential problems:
- If you’re getting out of debt, you’ll go back into it unless you have an emergency fund to cover it.
- If you’ve started building up your assets – your ISA or whatever – you’ll be taking a backwards step.
- If you’re already financially independent, you might need to go and earn some more money!
This might hit you a lot harder than other people. That’s because financial independence isn’t just about money, but the money is a measure of your progress to freedom. You’re not losing cash, you’re losing progress. Daniel Kahneman and Amos Tversky identified in 1979 that losses hurt a lot more than wins feel satisfying, i.e. they’re disproportionately weighted and it’ll hit you pretty hard to have a double-whammy. If you’re not going for financial independence, it’ll still hurt, but you’re only having a temporary cash flow setback.
Why I only have 3 months’ expenses in my emergency savings fund
When you choose how much to hold in an emergency fund, you need to think about how secure your current income is, how likely it is that you’ll get back to that level of income, and what you’ll put up with if you had to survive on the money.
How secure is your income, really?
I hate to be the bearer of doom and gloom, but your employer probably doesn’t care about you. Well, not really. Not deep down. When it comes down to it, companies exist to make money for shareholders. They’re not necessarily evil, but nor are they good. Companies are just a tool to group a bunch of people and stuff together and turn some money (shareholders’ investment) into profit (shareholders’ money). If your company stops achieving this objective, it will of course need to cut costs until the shareholders are getting profit. If you’re employed by a company, you’re the cost that’s getting cut. It’s not spite or meanness, it’s just how it goes.
That said, some people (like my partner) work for agencies where cutting or replacing people isn’t easy. Government workers, teachers, emergency services personnel – unless you deliberately try or become grossly negligent, you’re probably relatively safe. Well, relatively. You’d expect to at least know about it and get a decent redundancy package. This might mean that you need less in the fund than a freelancer, for example.
How likely are you to get back to that level of income?
If you have a highly sought-after skill, you’re probably pretty confident of finding other work if you lose one job. If you can ride that 517% growth in demand for blockchain developers, you’re sorted. However, if you’re already financially independent and you’re hoping for markets to be kind so that you can get rent/ dividends/ capital growth to pay you, a bigger cash buffer would be nice!
The idea here is that when you’ve used the emergency cash fund, you’re a little exposed until it builds back up. If it’s a bigger fund, you can take more hits before you’re at the whim of fate. Conversely, if your fund is about £1000 put your rent is £700 a month, you’re only ever one month away from needing your next wage/income payment. According to a Reuters article, you wouldn’t be alone. In 2019, Shelter claimed that millions of Brits were only one payslip away from ruin.
If you need a fair bit of cash to survive each month, you’re going to want more in that emergency savings fund!
What will you put up with?
Here’s an interesting thought experiment: how frugal could you be if you really had to be?
Thinking back to an earlier post on budgeting, there was a great interactive tool from the Office of National Statistics that broke down average UK household spend. The ONS reckoned that we spend £585.60 per week, on average. What struck me on that post though was how many of those costs added little or no value to households.
If push comes to shove and you really need to live in your emergency savings fund, how far can you make it stretch? How much can you cut? How soon can you cut it? The answers will be key to working out how big a savings pot you need.
My emergency savings fund
My fund is a little over £4,000. Yep, that’s right, it’s tiny. Here’s why:
How secure is my income?
My partner is working a government job and is pretty hard to sack. At the same time, I’m a trainee, basically covered under the apprenticeships rules (weird in my 30s, but career changing is just generally weird). So, although we can get sacked, it’s a safe bet that we’ll have a couple of months warning.
We’re also super frugal. I worked out that I live in 43% of my monthly take-home pay. Given that my partner does about the same, one of us could be unemployed at any one time and all that would happen is that the house would be cleaner and we’d stop investing for a bit.
This all means that I can get away with a smaller fund. Hooray!
How likely am I to get back to that level of income?
I’m pretty qualified in a few areas, so I’m reasonably confident that I could recover and find something if I was to be made redundant. I guess those side hustles would suddenly become a lot more important!
It’s fair to say that I’m pretty confident of at least earning my keep relatively quickly. Less in the pot, again!
What could I put up with?
My mortgage is quite small. We’re currently overpaying it. I could stop investing, cancel the TV licence and switch to a pay-as-you-go SIM on my mobile if I had to. I have no problems with charity shops for clothes, and I can cook – so rice and beans wouldn’t scare me, even if it was going to get boring very quickly. Worst comes to the worst, I could just use the library across the road and cancel all other forms of entertainment.
I’m also more than happy to throw myself into side hustles until I get myself back on track. Uber deliveries, anyone?
Again, another factor for keeping the money low.
How far will £4k really go?!
We based £4,000 on 3 months’ mortgage, feeding, utilities and internet, plus a buffer while we cancelled things in the first month. If we squeezed it, we can actually live on this for 4-5 months without too much pain, but I will be side hustling like it was going out of fashion.
If it came to month 3, we’d look at selling our assets. I’m a believer in diversification across asset classes, so something will be worth money at the point I need to start selling.
We’re also not that attached to our house. Sure, it’s our current home, but we’ve moved houses so frequently in the past that it’s no sacred calf. Could I sell the house for its equity if I really needed to? Absolutely!
As a result, we think 3 months in our situation is completely appropriate.
Changing after reaching CoastFI
Once we’ve achieved financial independence, I’ll change this weighting so that I have at least a year’s expenses in cash. This way, I can survive at least 12 months of downturn for stocks, gold, property (and anything else I have by that point!) before I start panicking. It’s not a perfect plan, but it’s enough for me to be comfortable with cutting ties with the workforce.
Why I don’t want too much money in my emergency savings fund
Cash has been making sweet nothing in interest. In May this year, the Bank of England’s Monetary Policy Committee voted to keep the bank rate at 0.1%. In real terms (i.e. after you factor in inflation), cash is getting less valuable over time. The target rate of sustainable inflation is 2%, which means that real return is going to be negative for a long time.
That means, logically, that having too much cash makes you poorer.
If you’d like a fuller explanation on how that works, see the post on how money is made.
