You don’t have a sound plan for your desired goals in life until you plan for emergencies and setbacks. In financial planning, this means planning for and building the right ‘safety net’, an amount of savings you set aside and only touch in case of an emergency. How should we evaluate the amount of savings required in a safety net? The answer varies by individual and household, but here are some general guidelines.
What are your needs?
The first step is to figure out what your needs might be. One of the main things we plan for is the loss of a job. If you lost your job, how much do you think you will need on a monthly basis to maintain a comfortable standard of living? It helps to have a budget, but getting a rough idea should not be too hard. Keep in mind that if you had to, you’d probably be able to cut some expenses, like eating out or expensive vacations. For example, say you make $100,000. If you lost your job and had to live on your safety net, your taxes will be minimal and you can probably postpone saving for other goals until you find another job. So you might only need to generate about 50% of your initial income to live relatively comfortably, or about $4,200 a month. One factor you may want to consider is your health condition. If you have recurring health expenses or there is a likelihood you may need additional funds for health expenses, you should plan for those separately in your safety net.
For How Long?
According to the Bureau of Labor Statistics, the median duration of unemployment is about 10 weeks. So a starting point can be to plan for about three months of expenses. But here is where individual circumstances can change quite a bit. The data shows that for about ⅓ of the population, unemployment can last longer than 15 weeks. If you are married and have only one source of income, it may make sense to increase the safety net up to 24 weeks, in case your unemployment lasts longer.
Your profession can help you determine how long you should plan for. Some professions are in demand, so a shorter time frame may make sense for those. Other, highly skilled workers in specialized fields may need a longer time to land the desired job, and so they may need to plan for a longer period. Continuing our example, if you are single and comfortable with the median estimate, your safety net estimate could be about $12,600 ($4,200 x 3). If you are married and your need is $6,000 for 6 months, your estimate would be $36,000.
Are you flexible?
Being flexible is always helpful. If you think you can get partial employment and income to cover part or all of your basic needs while you look for a better option, that income can help you lower the size of your safety net. But you have to be realistic, and consider that you may lose your job when there are few opportunities available. Having flexible needs can certainly help too. If you are renting, you could look for a cheaper option, or decide to have roommates. The more room you have to decrease your spending, the lower your safety net can be. Having some form of budget, even a simple one, can help you figure this out.
Do you have any flexibility with other goals? The goal of your safety net is so that you are prepared for an emergency, and you don’t need to give up on other important goals in case of an emergency. But perhaps you can use some flexibility with other goals. If you have been saving for a new car, you may decide to delay the purchase or to choose a less expensive model. Being flexible gives you more room to play across your savings.
Add a buffer
We don’t really know how much we might need when we actually need it, so it may be a good idea to add a buffer. The idea is to go through the steps outlined above, get a good idea of the size of your safety net, then add a buffer of 10-15% to it. One reason is to be on the safe side, in case you underestimated your needs. The buffer can also help you account for unexpected cost of living adjustments. With a buffer of 15%, the estimate in our example of a single individual goes up to about $15,000, while our married couple example goes up to over $41,000.
How to invest your safety net
By definition, the safety net should be invested in safe assets. High yield savings accounts work well, but you may also consider short-duration bond funds and Treasury inflation-protected securities or “TIPS.” The inflation protection can help you reduce the risk of unexpected inflation. If you use a buffer as we described above, you can invest your buffer more aggressively. It could even be completely invested in stocks. In our example of the single individual, you could invest $12,600 in a high yield savings account, and $2,400 in a stock market index fund. If the stocks increase in value, say to $3,000, move the additional $600 to the high yield account. If they drop in value, do not replenish it with the $12,600 you have in the high yield savings, as that is your core safety net. With this dynamic strategy, your buffer helps you increase the value of your safety net over time while protecting your essential safety net ($12,600) in down markets.
Safety net and Total assets
You may have been saving for a number of goals and have accumulated some savings. But unless your total assets are one or two orders of magnitude greater than your safety net needs, you should have a dedicated safety net, and only dip into it in an emergency. For many people, as they start saving, the safety net should be the first goal they fund. After that is taken care of, additional savings can be dedicated to other goals. The safety net is part of your basic risk management strategy that helps you grow your assets over time while giving you peace of mind that you and your family are taken care of in case of a financial emergency.
Your safety net should not feel like a waste of capital that could be used to get higher returns. On the contrary, It is the first step to achieving financial independence, as we are learning in this period of crisis. If you have a safety net, you can focus your portfolio on other goals and can take more risk with these investments, because you won’t need to dip into your investment portfolio in case of unforeseen expenses.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.