It goes by many names. Some call it a “rainy-day fund” or an “emergency fund”; others refer to it as “mattress money”. Whatever you call it, the function is the same. It is a buffer of protection against life’s unexpected occurrences. Think of it as insurance against some sort of unforeseen disaster, such as a pandemic perhaps?
“Just in case” seems a fitting name as it is the answer we typically give to our clients when they ask us why they should put aside so much money in cash savings. This advice may seem hypocritical to the client who has almost certainly been given a lecture or two on the insidious eroding affect inflation has on uninvested cash.
Just imagine for a moment, the following conversation taking place six months ago in December:
Advisor: You know, it would be a good idea to put some cash aside in a money market account for a rainy-day fund.
Client: A rainy-day fund? Why? I have life insurance, disability insurance, homeowner’s insurance, car insurance – I have everything I can think of already covered. Cash reserves will not earn anything at all. Why do I need a reserve fund or a rainy-day fund?
Advisor: Well, you know, just in case.
Client: Just in case of what?
Advisor: I don’t know. Who knows? Maybe a pandemic and our economy is shut down for months. Who knows?
It’s not what you don’t know that hurts you. It’s what you don’t know that you don’t know that gets you in trouble. In this case, it was a pandemic.
The fact is in times of real hardship, cash can be king. This is more evident than ever amid the global health and economic crisis we’re experiencing now. Overnight, revenues dried up for businesses and incomes vanished from individuals and families. In circumstances like this, cash on hand can mean the difference between survival and real loss.
The next question usually asked by the client is “how much of this ‘just in case’ money do I need?” There’s no easy answer to this question. Many rules of thumb get tossed around and are typically measured in terms of total monthly expenses: 1-3 months, 3-6 months, even 6-12 months.
Whatever rule of thumb the advisor gives, many clients will roll their eyes, shake their heads, and tell their advisor, “There’s no way; I have too many bills to pay. How could I afford that?” The advisor themselves may hesitate at this point. They may have a difficult enough time getting their clients to save for retirement, let alone some mystery event that may never happen.
Nevertheless, the advisor has a responsibility to at least attempt to persuade their client. This may require some perspective changing. “How could you afford not to? If you lost your income, how could you afford these bills you mention? How could you afford these expenses you deem necessary?”
No one wants to think about losing their job or source of income, but it happens all the time. Financial recessions, industry disruptions, pandemics, these are things no one can predict. Though they can’t be predicted, they can sure be planned for.
The human proclivity towards irrational thought and action rears its ugly head here. We tend to take an all or nothing approach to some things. If I can’t reach my goal of exercising every day, I’m just not going to exercise at all. If I can’t reach my goal of saving for six months of living expenses, I’m just not going to save anything at all.
How about exercising once or twice a week? How about saving for one or two months of living expenses? Exercising seven days a week is only 16% better than six days a week. Having twelve months of living expenses saved is only 9% better than eleven months. But no one can refute the fact that exercising one day a week and saving for one month of living expenses is 100% better than nothing.
Asking someone to put aside 6-12 months of living expenses is a big ask, but 1-2 is not. Having that 1-2 months of savings could be all someone needs. We are less than two months into the current economic shutdown, and restaurants are already beginning to open back up. If the average waitress, who’d be among the first to claim they have no room in their budget for a just-in-case-fund, had between just one and two months of living expenses saved, we would be in a much better place economically right now.
There does exist an alternative to a just-in-case-fund that may be a fair compromise for some individuals and families in certain situations. This alternative is having an emergency line of credit. For homeowners who haven’t already drawn upon the equity in their homes, the best emergency line of credit option would be a home equity line of credit, otherwise known as a HELOC.
HELOCs allow homeowners to have an open line of credit secured by the equity in their home. The amount of credit offered is typically around 80%-90% of the home’s appraised value minus the amount remaining on the home’s mortgage. For most, this amount satisfies the just-in-case-fund rules of thumb.
Additionally, what makes HELOCs a good alternative is the relatively low interest rates charged on the loans. Because the loans are secured by the home itself, they’re considered lower risk and are priced accordingly. A consumer credit card with a 20% interest rate is not a fair alternative to a just-in-case-fund.
Now is the perfect time for both client and advisor to reconsider and implement the just-in-case-fund. Clients may be feeling the pain from a lack of one, and advisors are forced to consider a major blind spot in their plans. The importance of having such insurance is evident before all our eyes and should take much less persuading as a result.