Last Updated on August 14, 2020
Financial safety net – isn’t that the same thing as an emergency fund? The short answer is no. The long answer is that an emergency fund is only part of the financial safety net equation. It’s essential to distinguish between the two. A financial safety net gives you a comprehensive plan of what you need to survive life’s unpredictable ups and downs. And while an emergency fund is certainly a critical piece of that picture, it’s only part of it.
The other components include various insurance policies which take some of the pressure of your pocketbook. Collectively, your financial safety net provides you with a diversified income protection plan, regardless of what life throws at you.
Why everyone needs an emergency fund
An emergency fund is basically a stash of cash saved up for bigger life disruptions. Things like getting into a car accident, losing a job, recovering from a natural disaster…or perhaps enduring a two month quarantine from a virus that shall not be named. You want enough cash set aside to float you and your expenses for a few months.
It’s important to note that an emergency fund is meant to cover expenses, not your salary. For starters, saving up a few months of cash to cover expenses is much more manageable than saving up a few month’s worth of gross income. Perhaps more importantly, keeping too much cash in an account that yields little to no interest, is typically not in your best interest, (pun intended).
How much money should be in your emergency fund?
Figuring out exactly how much money to keep in your emergency fund isn’t an exact science. A good place to start is by writing out a realistic budget of your expenses. Include some incidentals, but the focus should be on your essentials. If you lost your income for 3 months, I doubt you’ll still be buying $6 mocha-latte frappuccinos every morning.
Financial advisors suggest building an emergency fund with 3-6 months of worth expenses. That’s a wide range that attempts to account for differences in factors like sole family providers versus dual income households, and salaries which may be more or less stable than average. Some people are also just more comfortable with a bigger buffer.
If you’re feeling a little overwhelmed, the good news is that you don’t have to decide on one amount to stick to for the rest of your life. The key is to do your best at gauging your expenses. Life changes, and so should your financial safety net, including the amount in your emergency fund.
The consequences of saving too much or not enough
The amount you choose to save in your emergency fund is still important. However, it’s a delicate balance. Keeping too much money saved in a low-to-no yield savings account means you could be missing out on substantial growth. More than 3-6 months of expenses could be better utilized in a long term retirement account like an IRA or 401(k). However, if you save too little, you may deplete your savings and have to incur debt to cover your expenses. Worse than that, you may be forced take early disbursements out of your retirement accounts. Taking money out of 401(k) and IRA accounts too early not only causes you to lose out on market gains, but you’re also likely to incur some pretty nasty penalties and taxes. So, again – your best bet is to:
1. Calculate your expenses
2. Factor in your income stability
For example, commission-based salaries can vary quite a bit throughout the year and between years. With that, so can your expenses. If that’s the case, average it out.
3. Determine whether or not you can rely on any other sources of income
For example, a single income versus double income household. Could your spouse’s salary alone cover your collective expenses for a period of time?
4. Assess your comfort level to determine a buffer
If your comfort level requires a pretty large emergency fund, consider throwing that money into a high-yield savings account so that you are at least keeping pace with inflation.
5. Reassess the emergency fund amount each year
Put a recurring calendar reminder in your phone. I like to coincide mine with tax day so I can dump part of my tax return in there if need be.
What else makes up your financial safety net?
Here’s where you can take a little bit of pressure off yourself (and your emergency fund). No one can predict the future. So trying to save the right amount – not too much and not too little – doesn’t have to fall directly on you and your own pocket book.
Short term disability insurance
Consider short term disability insurance. But before you go out and buy a policy, double check all of that boring HR paperwork that you signed when you started your job – there’s a solid chance you may already have a plan in place. Many employers offer sponsored short term disability plans (meaning your employer covers some of the cost) to employees at little to no cost. I’m embarrassed to admit that I knew I had a plan, but I had absolutely no idea how much it was. And then I got rear-ended in my car…twice…in the span of two months. Fortunately, no one was seriously injured, and my car survived to fight another day.
The point here is that we often think about this type of coverage after something bad has happened. That doesn’t do you much good. I was lucky to not have sustained any significant injuries or auto repair expenses, but it would have been a drastically different story had that not been the outcome.
Short term disability insurance helps to replace a percentage of your income during periods that you cannot work due to illness or injury. It’s a great option to consider in supplement to your emergency fund. Many of us can manage to save 3-6 months worth of expenses, but what about 6 months, or a year? That’s a lot of money. And that amount of money sitting in your emergency fund would likely be better put to work in a growth account.
This is where short term disability insurance can help. Plans range between 9 and 52 weeks in coverage length and typically cover between 50-60% of your income, pending you meet the disbursement policy requirements; i.e. you’re actually ill or injured and cannot work. This can do a lot to augment how little or how much you’re able to put away into an emergency fund. But before you make any drastic changes to your savings plans, make sure you read the fine print to determine whether or not it covers what’s necessary for you, and whether or not that coverage is enough.
My business law professor used to joke that she’d never get a life insurance policy. She believed that it might incentivize her husband to make some less than ethical decisions. Jokes aside, this is a pretty fundamental piece of your financial safety net, especially if you have anyone else counting on you financially. While it feels a bit morbid to talk about, this is the whole point of financial planning; to make sure that you and those that count on you are taken care of, regardless of what happens.
Many employers also offer sponsored life insurance policies. So it’s worth it to double check if you already have one in place. The challenging part is to determine how much is enough, or appropriate for your given situation.
Life insurance policies vary quite a bit – so doing your homework will pay dividends here. The cost of your plan will differ depending mostly on two big factors: age and health. Speaking to a financial advisor about your specific situation can provide a lot of clarity here. To get you started, I recommend you check out this comprehensive guide.
The bottom line
Just like diversifying your income and skill set will benefit you in life, so will diversifying your income protection. Maybe you’re flying solo or maybe you have a whole tribe of kiddos. You don’t have to utilize every plan out there to create a comprehensive financial safety net. However, it is vital to take a hard look at your income, expenses, and your expectations for how to deal with life’s unpredictable ups and downs.