Should We Raise Emergency Fund Amounts Because of COVID-19?

This article is part of a series on personal finance during the coronavirus pandemic. Please check out the Coronavirus and Your Finances Series (link will open in a new window).

Every man is a fool for at least five minutes every day; wisdom consists in not exceeding the limit.
–Elber Hubbard
Elber Hubbard

Believe it or not, the “Raise emergency fund” is a relatively new concept in terms of its penetration in the U.S. psyche.

A search on Google yields no results for emergency funds relating to personal finance from 1990 – 1999, and only one “rainy day fund” relating to personal finance (a Church of Jesus Christ of Latter-Day Saints article in 1992 about starting out trying to save three months’ worth of expenses).

Yes, Grandma always talked about having money set aside in case of a rainy day, but not a lot of literature went on to support that notion.

Thus, it is unsurprising that a survey of people in 1977 and 1983 found unprepared to handle three months’ worth of expenses. Their review of the literature showed that most financial advisors in 1985 recommended 3 months of savings.

Even at that amount, most families were below the recommendations when it came to having liquid assets. In 1977, the median household had about 2 months of income in liquid funds, and in 1983, that had dropped to less than one month.

At the same time, the average length of unemployment in 1977 was 15.5 weeks, and in 1983, it was 19.4 weeks.

The story did not change during the Great Recession.

In 2009, roughly 25% of surveyed respondents said that they could come up with $2,000 in cash out of savings to spend on an emergency. In 2009, median household income was $50,221. So, 25% of households could cover 4% of annual income with their liquid savings – their emergency funds.

Meanwhile, the median duration of household unemployment in 2009 was 19.84 weeks. That duration would peak in June 2010, topping out at 25.2 weeks. But, let’s remember statistics. Median means that half of the people experienced less. Half experienced more. To compare, the average unemployment period in 2009 was 24.4 weeks, and in 2010, it was 33 weeks. That means that there were people out there who had much longer waits, skewing the averages higher.

The purpose of an emergency fund is to be able to use liquid assets (cash, CDs, money markets, etc.) to pay for expenses in a time of personal financial shock.

Generally speaking, those shocks come in a couple of broad categories:

But, as Nassim Nicholas Taleb explains in his book Antifragile: Things That Gain From Disorder (#aff), we shouldn’t prepare for averages, but, rather, for extremes, and be prepared to thrive in them. In one of the charts in the book, he lists debt (and, hence, illiquidity) as fragile, and having robust finances as being antifragile.

As we explained in “Asymmetric Outcomes: Why You Shouldn’t Invest Your COVID-19 Government Stimulus Check,” what you are trying to protect yourself from is a worst-case outcome: losing your home, going bankrupt, etc.

Thus, if you prepare for the average duration of unemployment, say 39 weeks, as we saw in 2011 and 2012 and now in the CARES Act, you’re still not fully preparing for what an emergency fund is supposed to prepare you for – a big, negative shock.

In the current state of the COVID-19 pandemic, all we have are best guesses as to the duration of the economic impact. While some economists project a rebound in Q3 2020, they don’t have much better of an idea than you and I do about what is going to happen. Furthermore, just because the economy rebounds, it doesn’t mean that if you lose your job, it’s going to come back when the economy does.

While we may be tempted to think of the coronavirus pandemic as a once-in-a-century event (a la polio or Spanish flu), the reality is that, while no other economic shock has come so abruptly, we have plenty in our lifetimes to remember:

  • Oil crisis and inflation in the 1970s
  • Black Monday
  • The dot com bubble
  • 9/11
  • The Great Recession

This won’t be the first or the last major shock we see in our lifetimes.

We started our early retirement with about 18 months of expenses in liquid assets, and that was without changing our lifestyles. So, while we’re certainly anxious, particularly since we rely heavily on rental income to support our FIRE expenses, our strong cash cushion gives us more time to wait and see how things play out before taking drastic actions.

If some retirement strategies recommend having 2 years of expenses in liquid asse, would that be a reasonable amount for pre-retirement emergency funds?

I doubt that an emergency fund needs to be so robust. The purpose of having so much money in cash in retirement is to allow for rebalancing in down markets without unduly tapping invested assets. In theory, if you are employed, you are refilling the other “buckets” with your income.

However, if you lose your job, you’re in the same position as a retiree, minus the assets to sustain you throughout the rest of your life.

The University of Chicago’s Steven Davis and Columbia University’s Till von Wachter showed that the 90th percentile job loss duration in 2011 was a little over 16 months.

When I was an active financial planner, I would run Monte Carlo simulations of people’s projected lifetimes. If they still had money when they peeled the garlic 90% of the time, they were good to go with their plans.

In this case, 16 months would be 90% of the job loss simulations.

Therefore, it seems prudent to have 16 months of expenses MINUS whatever you would be able to claim in unemployment (39 weeks in the CARES Act, 26 weeks normally) in an emergency fund.

That would be on the conservative side of the risk/reward spectrum, but, I’m willing to bet, those of us who have that much or more in liquid assets have significantly less stress than the 59% of Americans who cannot cover a $1,000 emergency in cash.

Is being able to cover 16 months of expenses too conservative? Not conservative enough? Just right? Let’s talk about it in the comments below!

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