Are Emergency Savings Funds a $1 Million Mistake?
Thursday, April 28, 2011 at 7:45AM How many times have you heard the boilerplate financial planning advice that you should save up to six months' expenses or salary in a liquid account as an emergency fund? On the surface it sounds reasonable and responsible, but have you ever looked inside the numbers? I mean, do you realize the negative impact on long-term savings and investing you can be doing to yourself if you prioritize your savings with an emergency funds push – and don't end up needing it?
If you're a young investor, say in your 20s just getting your career started, saving for a six-month emergency fund could be a $1 million mistake.
In short, my theory is based on the fact that the unemployment rate among 20-29 year-olds with college degrees is in the 4 percent range; less than half of the general population. And that's in today's economy. It's usually in the 2 percent range. It's unlikely, and not worth the risk of employing an overly conservative investment strategy, that a young professional will need to utilize such a robust, liquid emergency fund.
Let's use an example of a young professional making $50,000 per year. It would take approximately six or seven years to save six months' expenses even if done as aggressively as socking away 10 percent of after-tax income. If one did that at the expense of investing in an employer-sponsored 401k plan - or even of funding the 401k only to the point of receiving the company match - over the course of a normal working lifetime this individual would lose out on $1 million of savings.
Here's how it plays out graphically (based on a 4% salary increase per year; 9% annual return on investment funds):
Age | Income | After Taxes | Bank Acct | Investment Acct | Forego emergency fund; all 401k |
24 | $50,000 | $35,000 | $3,500 | $5,000 | |
25 | 52,000 | 36,400 | 7,140 | 10,650 | |
26 | 54,080 | 37,856 | 10,925 | 17,016 | |
27 | 56,243 | 39,370 | 14,862 | 24,172 | |
28 | 58,492 | 40,945 | 18,957 | 32,197 | |
29 | 60,832 | 42,582 | 23,215 | 41,178 | |
30 | 63,265 | 44,28 | 23,679 | $6,326 | 51,210 |
35 | 76,972 | 53,880 | 26,144 | 52,103 | 121,163 |
40 | 93,649 | 65,554 | 28,865 | 131,716 | 237,973 |
45 | 113,938 | 79,756 | 31,869 | 265,378 | 428,868 |
50 | 138,623 | 97,036 | 35,186 | 484,622 | 736,171 |
55 | 168,656 | 118,059 | 38,849 | 838,487 | 1,225,527 |
60 | 205,196 | 143,637 | 42,892 | 1,403,066 | 1,998,574 |
65 | 249,653 | 174,757 | 47,356 | 2,296,211 | 3,212,474 |
66 | 259,639 | 181,747 | 48,303 | 2,528,834 | 3,527,561 |
67 | 270,024 | 189,017 | 49,270 | 2,783,431 | 3,863,943 |
At the end of this person's working career, net worth for the one who saved six months' expenses in a cash account was $2,832,701, while the one who accepted the risk that he wouldn't need that aggressive of a cash reserve fund – and ended up being correct – had a retirement nest egg of $3,863,943.
Yes, this is a simple illustration and there are a ton of variables that can happen during one's career. But the premise remains the same. For many young investors, don't just blindly take boilerplate financial planning advice. Ask tough questions. Why do I need a six-month cash fund? What is the likelihood I'll need to access it based on my employ-ability? What other options would I have if I were to need emergency funds? Are 401k funds protected in bankruptcy? And what could I do with that money if I choose not to stash it in a cash fund?
Like you're seeing above, the difference can be staggering. Bottom line, be educated and do what's right for your individual situation and to meet your individual investment goals.
Reader Comments (1)
my comment here...