Fundamental #2: Maintain Enough Liquidity
This article, “Maintain Enough Liquidity,” is the second in a five-article series that discusses the Five Fundamentals of Fiscal Fitness, designed as a basic starting point to help you take control of your finances. If you do nothing else, following the Five Fundamentals will help you ensure that you are able to live within your means. There should be more to your financial plan than the Five Fundamentals, but following them allows you to move beyond living paycheck to paycheck, and focus on longer term financial goals, such as retirement planning, or saving for a specific goal, like college.
Keeping yourself honest by putting your savings plan first is a great start. But what happens when you have an emergency? You might have to dip into some of that savings to get through it. That’s where it pays to make sure that you can by having enough liquidity.
Before we begin, this article will look a lot like an article I previously wrote, “How Much Money Should I have in My Emergency Fund?” While the article stands on its own in terms of prescribing how much you should say, this chapter focuses specifically on why you should save. More importantly, you’ll come away with a better idea of what happens to the rest of your finances if you don’t have enough liquidity. Without liquidity, all of the financial planning efforts you take will be rendered worthless by the first emergency you encounter.
What Does “Have Enough Liquidity Mean?”
There’s a general rule of thumb in financial planning: “Everyone should have 3-6 months living expenses in cash.” Why do financial planners suggest this? We have to suggest something, right? We stress having enough money available for emergencies because we don’t want those emergencies to disrupt our clients’ long-term planning actions and goals.
If you establish a savings plan, then say, “but this month, we’re not setting aside this money because we have to pay a car repair bill,” you’ll never develop the consistent habits that lead to long-term financial success. What if you had to sell a bunch of stocks and mutual funds to pay an emergency room bill? What if the Dow was down for the year when you had to sell? You’d be a little stressed about missing out on the market’s eventual recovery. Having enough money to take care of your emergencies without having to sell securities resolves that concern, and it leaves investment money where it belongs—growing in investments over time. While dipping into an emergency cash fund isn’t the best thing, it’s easier to take a couple of months’ savings to replenish that emergency cash than it is to reorganize your finances every single time life throws you a curveball.
However, there’s a misconception. When’s the last time you had an emergency that required you to pay 6 months’ of your living expenses with no notice? The most common expense I can think of that might be close to that much money would be purchasing a car. Even then, buying a car is something most families plan for in advance, or set up a loan for if needed. Once, I did buy a car under emergent circumstances. My wife’s car was totaled by a drunk driver, and I was about a month out from a six month deployment. We financed it through our home equity line, then paid that off over the course of the next two years. However, this wasn’t an emergency that we expected to pay for with cash. It was a new car purchase, and it required a loan. Although we went through the process a lot more quickly than we would have under normal circumstances, we did not consider this an emergency, and neither should you.
The reason I tell you this is: While it’s not a bad idea to have a line of credit, it does not count as liquidity. A line of credit is pre-approval for an eventual loan. If you think of it as a loan, and commit yourself to loan payments, you’ll eventually pay it off. If you think of it as liquidity, then you’ll eventually just get used to the new balance every time you dip into it, and you’ll never pay it off. For argument’s sake, let’s eliminate any type of debt as a source of liquidity.
For a lot of people, 3-6 months’ expenses is such an unrealistic goal, so they don’t even try to take the first step.
So, let’s define having enough liquidity as being able to address two types of emergencies:
- Ordinary emergencies. These require emergency cash. Now. Or next week. Things like car repairs, a roof repair deductible or an emergency room bill count as sudden emergencies. They won’t have a permanent impact on your finances, and you’ll eventually be able to replenish your emergency cash. You don’t want to have to sell securities (especially if the market is down and you’re not getting as much out of those securities) to pay for emergencies. You want immediate access to pay for these emergencies.
- Extraordinary emergencies. These are things that will permanently change your life, and have a direct financial impact on you. Things like a forced early retirement, DUI, significant injury. All of these things will have a long-lasting, even permanent, financial impact, and you need to have enough liquidity to give you time and space to develop a long term plan and adjust. You might need some time to unlock the money from a maturing CD, or pull it out of an account. However, it’s still cash, or a cash-equivalent, and you won’t lose a lot of value like you would if you had to sell securities.
So, what do I need for an emergency?
First, there’s your emergency cash. Let’s take another step and assume that this will be emergency cash…not anything else but cold, hard, cash. Just like I indicate in my other article, it depends on your personal situation. You should have the following amounts saved:
- If you have a stable job and regular income, then set aside 10% of your annual income.
- If you have your own business or if your monthly income is variable (for example, based upon commissions or seasonal income), then set aside 20% of your annual income.
- If you are retired from all jobs (not just the military), then set aside 30% of your annual expenses (not income).
- If you’re retiring from the military, and expect to be unemployed, then you should set aside 40% of your annual expenses to offset whatever isn’t covered by your pension.
For extraordinary emergencies, your goal is to buy yourself time & space to make permanent adjustments. For this, you should have twice the amount of your emergency cash (for example, if you have $15,000 in emergency cash, you should have $30,000 that you can tap into for an extraordinary emergency). However, it doesn’t necessarily have to be a total of $45,000 sitting in your checking account. Your extraordinary emergency funds should still be in cash or cash equivalents, not invested in securities that can fluctuate in price.
Since you are only going to use this in the event of a life-changing occurrence, you can have use any of the following, or a combination:
- Checking/savings/money market accounts, as discussed above.
- Short-term CDs—3, 6, 9, or 12 month CDs. Make sure you have enough of a plan in place so that your CDs mature as you need them. For example, having a cushion to get you through the next 3 months, then having a 3-month CD mature which could get you through until the 6 month CD matures, and so on. While interest rates on CDs (or anything) are currently low, having a CD ladder in place can help you take advantage of reinvesting at higher rates as interest rates rise.
- Investment portfolios. Most investment portfolios have some sort of cash component in them, specifically for this purpose. If you have someone who manages your after-tax accounts, just having a set amount in cash fulfills this purpose.
- Retirement accounts. You might read this and think, “I don’t ever want to touch my retirement accounts, because of the taxes and penalties.” Let me assure you: if you HAVE to tap into this money, it’s for a far more important purpose than whether you’re getting a 10% penalty. Pay the taxes & penalties (not that you want to), and focus on getting your life on track.
Back to the retirement accounts. Most retirement accounts are in mutual funds with a programmed asset allocation. This asset allocation can be set in advance to have a cash component. For example, a 60/40 stock/bond portfolio might actually look more like 55/40/5, with 5% in cash. In TSP, you might have 25/25/25/20 in the C/S/I/F funds, and the remainder in the G fund. If you invest in L-funds, you may find that you’d have to liquidate the L-fund into the G-fund so that you can then get the money out that you need. This probably is not what you want to do, so you should consider other options before liquidating your L-fund.
Establishing sufficient liquidity is a crucial component of the Five Fundamentals of Fiscal Fitness, which are designed to help establish the foundation for your financial success. While we never want to have to tap into that liquidity, feeling the pinch in an emergency is a much better situation than feeling like you’re suffocating under the weight of your financial issues. In the next article, we’ll discuss how important it is to pay off all of your consumer debt.
So, how much liquidity do you have? If you had to spend $1,000 immediately to get your car fixed, could you? What about paying the bills for 3 months after your spouse lost their job? Please leave a comment below and let everyone know where you stand. Also, feel free to subscribe to this blog if you’d like to automatically receive future posts via email.
Caveat: Five Fundamentals of Fiscal Fitness is a money management philosophy created by Bert Whitehead, a prominent thought-leader in the fee-only financial planning world. Bert’s philosophy has been standardized by the Alliance of Comprehensive Planners (ACP), a non-profit membership of like-minded, fee-only financial planners dedicated to helping clients avoid the pitfalls of the financial services industry. Disclosure: I am a dues-paying member of ACP, and fully believe in the five fundamentals of fiscal fitness. Please feel free to contact me with any questions you may have about ACP and its philosophies.