The sunshine county of Sussex doesn’t often get battered by the weather. Our roads tend to get damaged more when the tarmac is melted by the sun than by being covered in snow. But Storm Eunice had the temerity to visit us on Friday, making for some interesting scenes along our coast.
Were you watching your fence, chimney or roof nervously? When the wind blows, our local fencing company expects a call from us (but not this time, thankfully!).
Many people were nervously looking at their finances as well as their fence or chimney, wondering if they are sufficiently resilient to cope with the worst of Eunice.
A shock like an unexpected storm can be a good time to reassess your financial resilience and to consider if you are sufficiently well prepared for future emergencies, whatever they might be.
The received wisdom from the financial advice community is that you should have between three and six months’ income put to one side, in cash or Premium Bonds, to enable you to cope with emergencies. This received wisdom doesn’t stand up to much scrutiny. It’s always struck me that there should be a more logical way of working out how much you need for emergencies.
In my experience, there are three determinants, which you should use to calculate the size of your emergency fund:
- Your stage of life
- Your access and attitude to borrowing
- The amount which makes you feel comfortable.
The most recent research into financial emergencies is some 7 years old now, but still useful; some things have changed since then (we’ve become more reliant on home computers and smart phones). But it’s clear from that research that your stage in life will affect the size of the emergency fund you need – in particular, people with children experience more unexpected costs in a year than those without children.
The most common unexpected costs were car repairs and replacement, opticians’ fees and glasses, dental costs, technology and phones, pets, washing machine and home repairs, and lending to family and friends. Lending to family and friends was the most expensive unexpected cost, followed by car repairs and replacements.
Some of these “unexpected costs” come up so frequently that they really shouldn’t be unexpected – for example, we should all be budgeting for repairs to our cars, and it’s fairly inevitable that you’ll need to replace your glasses every now and then. The best way to deal with these costs is through saving (these expected costs should be part of your annual budget).
If you are responsible for several cars (including those of young adults!), own your home (and maybe a holiday home), and have children and pets, it’s more likely that you’ll have to deal with a financial emergency, so your emergency fund should, therefore, be larger.
If you are employed, as opposed to being retired, it’s sensible to have some money set aside, which you can access, in case you lose your job – so, for this reason, during your working life, it’s advisable to have money set aside for this eventuality. Once you’ve retired, you don’t need to worry about losing your job, so there’s one less emergency to worry about, and your emergency fund can be smaller.
The availability of borrowing varies greatly from one person to another, according to life stage, but most of us are able to borrow money if we need to. Many take the view that there is no point in leaving cash available for emergencies, particularly as the returns paid by immediate access savings accounts are so poor. If you adopt this approach, when an emergency comes along, it can usually be covered on a credit card, at least in the short term, and the credit card balance can then be repaid. There is a logic to this for those who are working, particularly when credit cards offer extended zero interest periods. If you are in a position where you can clear debt quickly, and borrowing doesn’t result in sleepless nights, this is a reasonable approach.
However, many of us feel uncomfortable about borrowing, and the average number of unexpected costs per year is about 1.6, so, if you take this approach, it is perhaps inevitable that the credit card will need to be used during the year. So, if you don’t like going into the red, this won’t be the right approach for you. And it’s a terrible approach if you don’t clear the balance on your card.
Over the years, I’ve had many a conversation with clients about how large their fund for emergencies should be. And, much of the time, the logic about the size of the fund needed is outweighed by the “round number” in the client’s mind. I’ve always taken the view that, if the round number is larger than the logical calculation then that is fine, as long as the client realises that long term returns on emergency funds are generally lower than they are for invested funds.
The amount you set aside for emergencies is a matter of personal preference. It’s better to work out the amount you need in conjunction with a financial planner, who can act as a critical friend and help you decide how much you might need.
Philip Wise | firstname.lastname@example.org
Managing Director and Chartered Financial Planner