An approach to an “emergency fund”

A while back I tried to make the case that people don’t need emergency funds.

You should not have an emergency fund.

As I’ve read a few other similar-ish posts from PhysicianOnFire and EarlyRetirementNow…

Why I Don't Bother With an Emergency Fund - Physician on FIRE

Our emergency fund is exactly $0.00

…I’ve realised they all have too much emphasis on people who are already pretty established in life. Sure, if you have $100,000 in home equity and a $500,000 portfolio and your wife works and you have 2 rental properties…it is easier to make the case that you don’t need an emergency fund.

But that doesn’t really strike me as actionable advice for someone who is just getting started. What about them?

If a family saves 15% of their income each year then they are saving the equivalent of about 2 months of expenses every year. It would take them 3 years to save up 6-months of expenses. And that would mean forgoing retirement savings for those 3 years. That doesn’t seem like great advice; the opportunity cost just feels too high.

If you look at the traditional prioritizing investments advice then you’ll see that it looks like:

1. 401(k) up to employer match
2. HSA
3. Roth IRA
4. 401(k) to the max
5. Taxable savings

Let’s leave HSA aside for a moment — the restrictions on using it for qualified medical expenses complicates the following…

Going back to the family from above — the one that saves 15% a year. Assume they make $50,000 a year and so want to save $7,500 a year. Their savings strategy, following the traditional advice, would look something like:

1. Put $1,500 (3%) into the 401(k) to get the employer match.
2. Put $5,500 into a Roth IRA
3. Put the last $500 into the 401(k)

Lots of people have pointed out that you can use a Roth IRA as an emergency fund. Which is great advice! My only point of disagreement is the hedging in that article. Instead of saying “in certain appropriate cases” I think it should be the default advice for everyone:

Your Roth IRA is your emergency fund.

There is one other wrinkle I’d add on this. A lot of people look at an emergency fund as a source of short-term liquidity if something happens. Maybe you work for the government and, thanks, to the government shutdown your paycheck is going to be delayed a week or two. How do you make your mortgage payment?

You could get that money out of your Roth IRA but that process will probably take a few days, maybe even a week, before the money lands in your account. Maybe you don’t have those couple of days.

This is why I’m a fan of YouNeedABudget’s Rule 4: Age Your Money.

Some might argue that this is the same as a 1-month emergency fund. I don’t see it that way — with an emergency fund the money doesn’t have a use assigned to it, it is just sitting there; with YNAB’s approach the money has a use assigned to it but that use is ~30 days in the future. But I don’t think it is a point worth arguing over.

Put the two things together and my recommendation for someone starting out in life would be:

1. Always contribute a few percent to your 401k to get your employer match.
2. Then work on YNABs’ Rule 4 and Age Your Money. This step could take you anywhere from 3–9 months after you get your first job.
3. Then start contributing to your Roth IRA, keeping in mind that if you ever have an emergency you can tap it.

Your Roth IRA should be a relatively conservative investment to start out with. This Roth IRA is acting as both a retirement investment (long investment horizon) and as a potential source of liquidity during an emergency (short investment horizon). I would probably structure it something like this:

1. Keep your Roth IRA at a 50/50 asset allocation to start with. (There’s no strong math or analysis behind that; it just feels like a reasonable compromise position between the long-term and short-term horizons.) This means your 401k will be invested in 100% equities. But it means that, especially when you are first starting out, that your asset allocation has substantially less allocated to equities than most books and articles suggest. You won’t be 90% or 100% equities, despite your young age. Instead you’ll be at something like 55% equities to start with. And that might last a few years, depending on the market and your own savings.
2. As the balance of your Roth IRA grows, you can shift it to be less conservative. (This means you’ll have something like a rising equity glidepath for the first several years of your working & investing life.) Once your Roth IRA balance has reached the equivalent of six months of expenses — a process that might take you a few years — you could direct all new contributions to 100% equities. (A 50/50 Roth that is six months of expenses means 3 months of expenses in bonds and 3 months of expenses in equities.)

If it feels like “hey, instead of having a dedicated emergency fund, you’re just telling me to have a few months worth of bonds in my Roth IRA”…well, that’s exactly what I’m saying.

You don’t need a dedicated emergency fund held in taxable kept in a high-yield savings account. You just need something that is relatively liquid and relatively stable in price value. And you don’t need a 100% guarantee for either of those.

If your “Roth IRA virtual emergency fund” drops 10% (which would require equities to drop 20%, given that I recommended a 50/50 asset allocation to start out) that’s not the end of the world. You thought you had 4 months of expenses and now you have 3.6 months of expenses. Don’t pretend that “4 months of expenses” was somehow the mathematically perfect number and anything less is disaster. Maybe 3 months of expenses is enough to cover the emergency? Maybe even 6 months of expenses wouldn’t have been enough.

If someone can max out their 401k, IRAs, HSAs, and still build up a 6- or 12-month emergency fund in taxable then they are making so much money it doesn’t matter much what they do. Have an emergency fund. Don’t have an emergency fund. It becomes about psychological factors more than anything else.

There’s nothing with that. There’s a lot of research (plus common sense) showing that people just feel better when they have some amount of “cash” (as opposed to “investments”) readily available.

But remember that that is a luxury and I’ve slowly come around to the belief that investing for retirement requires a fair amount of HTFU. Instead of always doing what makes us feel better, sometimes we need to do something that will be better for us in the long run and learn to deal with the short term discomfort.