In my youth, when people talked about having an emergency fund, I was like, “Man, I’m just trying to pay my electric bill this month. I can’t even imagine an emergency fund.” Then, as I grew up, I noticed high-income earners complaining about “excess emergency funds.” That idea of excess blew me away. I thought, “So you are telling me you have so much money you don’t know what to do with it?”
Now that I’ve been in the advisory business long enough and helped thousands of families, I see this as not necessarily a problem to solve but an opportunity to help families be good stewards of their resources. The strategy of keeping excess emergency funds in an account not earning interest is the same as putting money under the mattress. There are better approaches.
So, let’s first get on the same page about how much is “too much” emergency fund. Most people should have six months times their monthly expenses in an account set aside for emergencies. Don’t confuse this statement with six times monthly “income.” That’s a different number and generally a much higher one, as well.
Also, there’s a reason behind the six-month number. The rationale is that if you are working and have a disability, your long-term disability usually has a three-month waiting period before it starts paying out. That payout could be delayed beyond three months if the claim is complex. So, six months of cash would likely cover your family’s bills before the insurance company cuts you a monthly check.
Now, if you are a two-income household or someone with a monthly pension, you may be able to get by with only a three-month emergency fund.
If you are retired, I recommend having a one-year emergency fund. It seems like a lot, given that a retiree’s expenses generally aren’t as high and Social Security is kicking in, but there is a fundamental strategy when you have a large cushion in retirement. For example, if the market crashes, you can stop withdrawals from your investments and live off your super-sized emergency fund while waiting for the market to recover.
Now that you know the general framework for using an emergency fund, any cash over and above those personalized numbers is considered excess. This excess not only applies to individuals but also to businesses, churches, trusts and nonprofits.
So, what do you do with this excess emergency fund? Investing it in the stock market is an option, but you may have reservations because of the volatility. What about the bond market? It may have been a while since you’ve considered the bond market because you couldn’t get the yield you wanted. As Federal Reserve Chair Jerome Powell has turned up the heat on interest rates, bonds are now a worthy recipient of excess emergency fund money.
Although you can buy individual bonds, most people will look at the mutual fund and exchange-traded fund market to get access to bonds. This method allows one to own multiple bonds simultaneously without subjecting them to an individual bond default risk. It’s the essence of diversification and not putting all your eggs in one basket.
When examining bond funds, consider the length of the bonds in the fund, often stated in the actual name of the fund, such as short, intermediate and long. The longer the basket of bonds, the more interest rate risk you have. Also, you have to factor in the credit quality of the bonds. The lower the credit quality, the higher the yield, but the more volatility.
After comparing a few bond funds with your advisor, you can decide if the return difference between the bond funds and your current CD at the bank is worth the investment. Each difference in improved yield can be significant cash if you have a five-year or longer time horizon.
Given that 37% of Americans can’t afford a $400 emergency, having excess emergency funds is a blessing rather than a problem. So, rather than considering it a point of frustration, look at it as an opportunity to improve your return on investment by strategically using the much-improved bond market.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.