Rethinking the Emergency Fund

A lot of what we talk about here is specific to people on the early retirement path, but today’s topic is something every single one of us should have as an important part of our financial plan: an emergency fund. We think of our emergency fund not as a one-and-done kinda thing, but as something that has evolved upward and downward over time. And now, as we’re approaching early retirement, we’re once again rethinking how much we need to have saved in our e-fund when we hit our magical date.

Somewhere along the line, I was heavily influenced by that wacky Suze Orman, who espoused the virtues of an emergency fund that can cover a full eight months of living expenses, which is pretty far beyond the three-to-six months that most planners (including Dave Ramsey) recommend. And so for years, we’ve been those diligent worker bees who looked at what we’d need to get by in a given month, and adjusted our emergency fund to match eight of those. That’s all after we saved up to have an emergency fund, of course. What do you think? Did we overdo it?

The Evolution of Our Emergency Fund

2005 — We get together. I have about $35,000 in debt (student loans, credit card debt and a car loan), a few hundred dollars socked away in a super conservative bond mutual fund, a baby 401(k) and maybe $100 in savings. I think of credit cards as “emergency funds.” Mr. ONL is three years older, so does exotic things like max out his 401(k), and has some mutual funds. But no emergency fund.

2006 — We move in together, and decide to get smart about our finances, which really only means attacking my debt. Emergency fund value: $0.

2007 — While aggressively paying down debt, I discover Suze Orman, and decide we need an emergency fund, preferably all eight months worth of expenses, which at the time equals about $25,000. We start saving for both our emergency fund and a future home purchase. Emergency fund value: $10,000.

2008 — Debt free at last. We have a big year: filling up our emergency fund, continuing to save for a home, and getting married. Emergency fund value: $25,000.

2009 — Buy our first place, a condo in the big city, which raises our monthly expenses. Eight months worth of basic expenses now equals $32,000, which we hang onto after making our down payment. Nearly throw up the day the down payment gets wired to escrow company. Emergency fund value: $32,000.

2011 — Buy our mountain house, but still have our city condo. For some reason we think this makes sense. I know. #balleryears. Now need a bigger emergency fund to cover it all. Emergency fund value: $48,000.

2013 — Come to our senses and sell the city condo. Invest the proceeds in Vanguard along with part of our emergency fund, and buy our rental property. Emergency fund value: $40,000.

2015 — Realize that we’ve achieved financial independence, live more cheaply, and don’t need so much money earning close to zero percent interest in a savings account. Reduce emergency fund. Emergency fund value: $25,000.

2018 — Future us have retired early. We own our home outright, we have ample insurance and savings, and our monthly expenses are minimal. Emergency fund value: ??

What’s the Right Amount for an Emergency Fund?

Our emergency fund balance has gone up and down quite a bit over time. And the philosophy surrounding it has evolved too. We’re pretty sure we overdid it for a lot of years, because we followed the eight-month rule blindly, without considering other factors. Never mind that we always had two incomes, either one of which could cover most or all of our basic expenses in the event that one of us lost a job — the odds of us both losing them at the same time would be super slim. Never mind that our emergency fund has never earned more than the most meager interest rate, guaranteeing that we lose spending power every month to inflation. Never mind that we have always been well insured (maybe over insured?), and would have minimal exposure in the event of a natural disaster. We wanted to be prepared!

It’s not like we’re beating ourselves up about it. We’d always rather be overprepared than underprepared. But there is a little bit of face palm action when we think about how much we kept locked in 1 percent interest rate savings accounts for years, when it could have instead been growing during the S&P 500’s hot years.

Thinking about emergency funds now, there are a bunch of factors worth considering:

• What’s our bare minimum budget, subtracting everything we can’t cancel or postpone, and forgoing all the luxuries? In other words, what’s the least we could get by on each month, without sacrificing food, shelter or heat?
• Are we reliant on a single income or two? In our case, with two incomes, do we need both incomes to live, or could we do just fine on one?
• What are the deductibles/annual out-of-pocket maximums (or “maxima,” for you math and/or grammar nerds) for all of our insurance plans, in the event that something catastrophic and bizarrely serendipitous happens which requires us to shell out for every deductible/annual max at once?
• If a car dies, do we have another option besides immediately buying another car? (We have two cars, and could figure out how to get by on one.)
• What are the other factors in life that might constitute an emergency that wouldn’t be covered by insurance? (Last-minute flight to care for a dying loved one, temporary housing while rebuilding our house post-wildfire, etc.)

With those answers, we think in our case we’re fine with a smaller emergency fund than we’ve had in the past, at least while we’re working, because we’d be okay losing one income, and now have enough saved up that we’d actually be fine if we lost both incomes. We also wouldn’t be forced to rush out and buy another car, and the total of all of our insurance deductibles and OOP maxes is under $10K (most of that is health insurance OOP max).

The Magic of the “Life Happens” Fund

As our emergency fund has fluctuated up and down over the years, one of the things that hasn’t changed recently is something we instituted a handful of years ago: our “life happens” fund. This is another concept from Suze, and separates out the kinds of things that we know will happen (we’ll owe some taxes every April, for example, or need to do some costly home maintenance every summer — mountain weather and high altitude sun are tough on houses) from the true emergencies.

For the past five years or so, we’ve kept about $20,000 in our “life happens” fund, which is housed at USAA along with our other bank accounts. (Or emergency fund is offsite at Ally, earning a slightly better interest rate, along with being deliberately harder to access.) Remember those “whoops” work travel expenses I had to float last December, because I hadn’t gotten my expense reports in on time? That was only possible because of the life happens fund. Same goes for the big and surprising federal tax bill we just had to shell out. And same would go if a car died and we needed to buy a replacement.

Sure, the life happens fund doesn’t earn a very good interest rate. But it more than makes up for it in peace of mind for us.

How Big An E-Fund Do We Need in Retirement?

The big question we’re tackling now is: How much do we need in our emergency fund in retirement? We’ll have plenty of funds saved, but those are mostly dollars that we need to last us a long time, not money we can just throw at problems that pop up. So we think it’s essential to have some amount set aside to cover true emergencies, while not keeping so much in emergency savings that we lose a ton of value to inflation.

But how much depends a lot on what we’re already budgeting for. A good chunk of our annual retirement budget already accounts for health insurance premiums (premia, nerds) and OOP maxes, covering us on the health front. On the natural disaster front, we’ll of course be insured, but the biggest threat there is the cost of having a place to stay while our place gets rebuilt, if it came to that. Rather than pay rent for a year or two (not out of the question in a mountain town with only so much construction labor!), we’d just buy a small RV (or maybe we’ll already have one by then) and live on the road, which is far less costly. We’re budgeting for a replacement car every so many years, and can do plenty in retirement without one, unlike now, with all the required airport back-and-forth.

We also have a slew of general contingencies, including downsizing our home, selling our rental property, moving into our rental and selling the main house, doing the Roth conversion ladder with some of our well-funded 401(k) dollars, and a few other options.

But, despite having accounted for a lot of things in our planning, we also expect to be retired for a long time! And while we could certainly absorb certain emergency expenses by just spending less that year or even for a few years, the same way we expect to adapt to poor market performance years, it would definitely keep me up at night if I thought we were one disaster away from our whole retirement plan falling apart. So the answer is: We haven’t decided how much of an e-fund we need in retirement, but we know we want to keep one.

Please chime in! For those already retired, how did you decide how much to keep in your retirement emergency fund? For those in the planning stages, how are you thinking about this question? And does anyone else use the “life happens” fund and love it as much as we do? Please share in the comments!