I decided to make some significant changes to my Emergency Fund this month. Here’s my reasoning and decision, plus an updated section to my Charter describing my new plan.
What is an Emergency Fund?
An Emergency Fund is money put aside for, well, emergencies. An Emergency is considered an unexpected expense or demand for cash, say, an expensive repair to a car / house, or even losing your job. Having funds put aside mean there’s a lower chance of going into debt when these expenses show up.
Everyone has their own definition of an Emergency as well as the required size of the Fund. It’s usually several months of expenses. Typically an Emergency Fund is held in cash or for larger amounts, some kind of tiered approach with cash / CDs / short-term treasury bonds.
Evolution of my Emergency Fund
My emergency fund plans have changed a couple of times over the last two years. I initially wrote about my plans to Master disaster by keeping six months of expenses in Cash. After some thoughts about managing uncertainty, I updated my plan by increasing the amount to ten months and invested the money in a combination of bonds and stocks instead. Then in March this year I revisited my plan a third time and went to 100% in stocks (via VTSAX, a Total Stock Market fund), still with a ten month target.
The risk / volatility of holding the funds in VTSAX was mitigated by holding a higher amount. So on worst case conditions, if the fund dropped 50% in value, I’d still have five months of expenses.
The value of my VTSAX holding was $42,701.21 at the end of November. That’s $3,700 above my target amount, and represents a 10% gain on the cost basis of $38,946 that I’ve put into the fund over the last year.
Now all of this jiggering about stems from two main thoughts.
- Keeping a bunch of Cash around and keeping it up to date with Inflation is a drag.
- I don’t think I need an Emergency Fund but I’m stuck on mental accounting and know that I’m supposed to have one.
1. A Cash Drag
The first point is really a first-world problem. Keeping a lot of money around in a 1% savings account is losing value to inflation. Even though I can manage my Personal inflation rate, chances are that I’d need to top-up the EF each year.
Let’s say next year I increase my monthly budget by $100 to $4,000 a month. I’m now required to find ten times the increase, or $1,000, to keep my EF at its target level.
I must admit that I don’t like having to divert income each year to feed into a ‘lazy’ account that I’ve never touched in four years or so. This was really the reason I started investing it in the first place.
2. Is it even needed?
My EF was intended for covering loss of employment rather than large expenses. That’s what my Savings are for, and I generally try to save in categories where I expect large expenses.
So my Savings is already part EF and part “Future Wants”. I expect that the HVAC system in my house will need repair at some point, so some of my Savings is put aside for that. Ditto the kitchen appliances, washing machine, etc. I also want to replace my PC at some point so some of my monthly savings goes towards that too. But if push came to shove, I’d delay the new PC purchase, or the future house down payment and use that money for something more urgent.
I have $74,870 in my Savings accounts at the end of November, almost twice the size of my EF account. These accounts are kept separate from my EF (and in more conservative assets). If push came to really hard shove, then I also have $270k+ in my Income Fund that I could tap into. After paying off the mortgage, I could get by for over three years without any income.
What I like about my Savings is that I don’t put any arbitrary upper limit on the account size. The money allocated to it also has a purpose. If needed that purpose can be modified based on newly identified needs. This is purely psychological on my part, but I like having Savings whereas an Emergency Fund feels like an obligation.
So what to do?
Given that my Income Fund will also eventually pay my Living Expenses, I’ve decided that I may as well just roll my EF money into my Income Fund, with two provisions:
- I’ll keep the money within the Income Fund in a higher quality / more stable Bond Fund than I own today.
- The target allocation will be a fixed percent of the total fund size, and not limited by a set number of months.
What this really means is that if I lost my employment then I’d have the option of withdrawing some of my Income Fund. Whereas previously I’d be spending from an alternate account. Money is fungible so I may as well just consolidate it and have one less thing to track.
Since my Income Fund should eventually provide sufficient income for FIRE, then the need for an Emergency Fund against job-loss eventually disappears. This change is really just spending up that process but keeping the funds in a more stable investment in the mean time.
- As of 12-December, I’ve sold all of my VTSAX holdings for $43,866.95. This represents a capital gain of $4,918.49 based on my cost basis. This is a mix of long-term and short-term gains with about $1,000 of taxes due next year. However it’s $5,000 that I didn’t have in the first place, so I’m okay with that.
- The proceeds went into $39,480.23 worth of VMMXX (a Money Market Fund) and $4,386.72 which I added to Bonds in my Income Fund. I’ll detail the Income Fund investment in another post as I made some other changes to the asset allocation this month.
- I plan to exchange the total amount of VMMXX into my Income Fund over the coming year. I want to do this gradually to keep the asset allocation closer to my target.
My Updated Charter
Here’s the updated Emergency Section going into my Charter.
The Emergency Fund is reserved for supplemental income in the case of unemployment.
The Emergency Fund shall be at least a 10% asset allocation of my Income Fund held in short and/or intermediate term passively managed Bond Funds.
Number of months of Living Expenses. The Emergency Fund shall be reported based on the total market value of the allocated investments divided by the current monthly budget.
Combining my Emergency Fund into my Income Fund was a big mental step for me, as I like to compartmentalize. However I like the fact that I’m now really down to three “buckets” of money: Living Expenses/Cash, Savings and Investments/Income Fund.
I could have categorized the Emergency Fund as a component of my Savings instead. However ironically I’d then be more likely to spend or borrow against it. That’s because my Savings are really reserved to be spent at some future point. Money withdrawn from my Income Fund, on the other hand, should only come from dividend / interest earned, and not the invested capital.
There’s a lot of psychology in handling money as you can tell from this post. But I wanted to write down my thoughts on how I arrived at this decision. I’m excited about this change going forward; it helps simplify my finances and maintains money reserved for Emergencies.
Quote of the Day
I’m shakin’ the dust of this crummy little town off my feet and I’m gonna see the world. Italy, Greece, the Parthenon, the Coliseum. Then, I’m comin’ back here to go to college and see what they know. And then I’m gonna build things. I’m gonna build airfields, I’m gonna build skyscrapers a hundred stories high, I’m gonna build bridges a mile long…