A Phased Approach to Emergency Funds

In my recent post on my approach to bonds and cash, I mentioned that I don’t have any dedicated emergency fund at all. I know this flies in the face of conventional personal finance wisdom, but I think I’ve got a pretty sound justification. My personal approach is not quite so aggressive as somebody like Early Retirement Now, with a 100% equity portfolio and emergencies funded through a combination of credit card float, cashflow, home equity line of credit, and a worst case equity sale. It’s not that I disagree with ERN’s logic, and I fully believe that his approach is mathematically the highest return one, but my risk appetite is a bit lower – that’s just what helps me sleep at night.

Over the years, I’ve gone through three distinct phases of emergency funds – while these might not be for everybody, I think they’re a reasonable framework for thinking about an emergency fund as you mature in your finances.

Phase 0: Crisis Finance

I’m cheating with Phase 0 because I’m in the very fortunate position that I never really went through it myself. This is where you’re living paycheck to paycheck and frequently not having enough at the end of the month, dipping into payday loans, borrowing from friends, racking up credit card debt, and the like.

In this situation, it totally makes sense to me to have a small emergency fund (few hundred £ maybe) just to smooth out the inevitable bumps in life. Clearly the main focus here is getting out of the paycheck to paycheck cycle!

Phase 1 : Dedicated Emergency Fund

This is where I was basically from leaving home through most of my 20s, and lines up with conventional personal finance advice. I was starting to invest, but most of those investments were locked away in my TSP (military 401k), not much I could call on in an emergency. So, I had a dedicated high-yield savings account I considered my “emergency fund.”

You’d want to tailor how much is in this fund to your own situation – I had a very secure job for most of this time (the Navy tends not to fire people on short notice) that also came with very good healthcare, plus relatively low fixed expenses (I was single, renting, no major loans), so this didn’t need to be a ton of money, maybe a few months of expenses. I can’t really recall having to dip into it for anything big, maybe some car repairs, but it gave me piece of mind.

Of course, if you have large fixed expenses, a “flexible” (aka unreliable) job, and/or health issues (for those readers in the US – not as much as concern if you’re in the UK with the NHS), then that argues for a substantially larger pot.

I grew out of this phase from a combination of three factors:

  1. Got out of the military and into a good job, but it wasn’t rock-solid like the Navy
  2. Bought a house, got married, had kids – bigger fixed expenses and less ability to tighten my belt
  3. Steadily growing net worth, including starting to have more money in easily accessible investments through a taxable brokerage account

Phase 2: Discrete Savings Pots

All those things happened around the same time – I don’t think any one of them alone pushed me into this next phase, and it’s kind of a fuzzy line. But I started realizing that my “emergency fund” was doing two very different things:

  1. Insuring us against a major emergency – protracted job loss being the most likely, major health spending the other primary possibility (still in the US at this point, although my insurance was pretty decent).
  2. Smoothing out irregular expenses – some of this was lumpy within a year (oil-fired heating costs a lot in the winter, car insurance paid annually, that kind of thing), and some spread over multiple years (boilers, hot water heaters, roofs, appliances, cars – all eventually need replacing and maybe irregular repairs).

Bucket #2 isn’t really an emergency, since these are things that we know will happen, even if we don’t know exactly when or how much. At this point, I had some guesstimates on what this spending looked like, and set up buckets to build up incrementally every month. For example, $250 a month to utilities, but in the summer it’s more like $100 and winter more like $400 actual spend, so the account grew in summer and shrank in winter, aiming to be just a bit above $0 come the warmth in spring. At the time, these were actual separate bank accounts, although all at my main bank. Eventually they just became lines on a spreadsheet, mostly due to moving to the UK and not wanting to deal with so many actual accounts – you could do the same thing with “pots” in Monzo, Starling, etc.

Bucket #1 was still a “real” emergency fund, but as my investments grew, I started to get comfortable with some of that fund being invested. Given my experience and the Boston area job market, I wasn’t expecting to be out of work for long, even if I was laid off or my company folded, so I was pretty ok having maybe three months of expenses in cash, and the rest accessible from a taxable brokerage account. I was doing a gut feel calculation, not too much math behind it, but figured the expected returns were worth the potential risk of having to sell in a downturn. Everybody will make a different call on this, and that’s ok!

That risk panned out for me – whether that’s luck or just good risk management, I’ll leave to you. But this was around 2015, so with reinvested dividends that money has nearly tripled since then!

I kept this approach for a good 6 years or so, until very recently. There’s no time limit on it, and I think the transition to the next phase is more emotional than quantitative.

Phase 3: Consolidated Cash & Bonds

As part of my recent thinking on asset allocation and the role of cash+bonds in my portfolio, I realized that my dedicated “emergency fund” served no real purpose. I’d actually been slowly reducing that line on the spreadsheet anyway, because my other short-term cash savings were high enough that it seemed silly to keep so much cash, but that wasn’t entirely a deliberate decision, more just gut feel.

Now, I actually have a logical basis:

  1. My cash+bonds allocation, at 21%, is already about 2.5 years of normal budgeted spending, more than any emergency worth planning for. In a real emergency, we’d cut spending back to push that well past 3 years.
    • There are “black swan” kind of events this won’t cover – if my wife and I both get injured and can never work again, say. But no emergency fund can practically insure against that – you only insure against never working again by fully achieving financial independence, and we aren’t quite there yet.
  2. My cash+bonds allocation is very safe, with extremely limited volatility
    • Mine is safer than a conventional bonds approach, with it being primarily the TSP G fund, Series EE bonds, and Premium Bonds – issued and guaranteed by the US and UK governments, with no chance of loss of capital.
    • But even if you were in 100% BND or similar, take a look at the chart and see how big the biggest drops are – absolutely tiny compared to stocks. Something like a 7% drop during the COVID drop in 2020, compared to an almost 50% drop in a US total market fund.
  3. I have good control over the non-emergency lumpy expenses. Practically, they largely come out of cashflow (via credit card float), although I’m still tracking my buckets on a spreadsheet, more for budget measurement than any sort of real concern over emergencies. They’re pretty theoretical buckets within the cash part of the bond+cash allocation, but I find them helpful to see if my budget stays realistic – since my current budget is also my expected retirement budget, it’s important that I know how much I’m spending.
  4. I have ample credit available. I’ve never needed to use it (pay off your credit cards in full every month!), but I’ve got 6+ months of normal budgeted spending available on my credit cards. Sure, not everything can go on a credit card, but combine that with the cash+bonds allocation and tightening our belts and we get to something approaching 4 years of spending before needing to touch equities.

Put that all together, and I don’t see a point in having another pot of cash labelled as an “emergency fund” anymore – that would really just tilt my asset allocation more towards bonds+cash for the purposes of semantics.

Special Considerations for Americans in the UK

Pretty much everything I said above applies whether you live in the US, UK, or almost anywhere else – only caveat being around health care expenses as a very plausible emergency in the US, but a much smaller financial impact in the UK.

A few caveats specific to Americans in the UK, though:

  • Currency risk is real, so take that into account when deciding where to put your emergency fund, if you have one, or your cash+bonds allocation.
    • It’s safest if your emergency fund is in the currency where most of your expenses are – probably GBP for most of us in the UK.
    • For the past few decades, the pound has mostly fallen relative to the dollar, so you’d actually make out to your advantage if, for example, you’d had your emergency fund in USD just before the Brexit vote dropped the value of the pound from about $1.60 to $1.20.
    • There’s no reason to think that trend has to continue though – you could easily have the pound appreciate just as your emergency happens. If that same situation were reversed and the pound climbed from $1.20 to $1.60, your USD-denominated emergency fund has dropped, in GBP terms, by a quarter. Your 6 month fund now only covers 4.5 months!
    • Personally, if I was still in the Phase 1 or maybe Phase 2 mode, I would have my dedicated emergency fund in GBP only – it’s entire purpose is to help me sleep at night, and exposing that fund to currency risk just gives you another thing to worry about. In Phase 2, if you’re starting to expose some of your e-fund to market risk, maybe it’s ok to also add some currency risk – just be aware of how much risk you’ve added!
    • In my current situation, I’m not worried that about a third of my cash+bonds allocation is in USD. Even the remaining two-thirds is still a healthy cushion, if a major currency swing were to coincide with my emergency.
  • Taxes are still inevitably complicated, although it’s not too bad for most of the kinds of accounts you’ll use for an emergency fund
    • Big picture, the UK and US both tax interest from savings accounts or bonds as income, so you’ll be taxed at whatever your marginal income tax rate is (20, 40, 60, or 45% in the UK; 10, 12, 22, 24, 32, 35, or 37% in the US). The UK has a pretty generous personal savings allowance, at £1,000 (basic rate), £500 (higher rate), phasing out at the additional 45% tax rate. So if you’re under that UK PSA, you may well owe a bit to the US if you don’t have other passive category foreign tax credits to offset it, or if you’re using the Foreign Earned Income Exclusion (since this isn’t earned income, the FEIE doesn’t help).
    • Realistically, you’re not going to make that much interest on an emergency fund today. Even a quite big e-fund – say £6,000 monthly spending and you want 12 months of spending, so £72,000 – is making you something like £720 a year at 1%, maybe £1,080 at 1.5%. Even at the highest tax brackets, that’s not a huge impact on your finances, but I know we’d all prefer to pay as little as legally feasible to HMRC & the IRS.
    • A few ways of cutting back on the tax:
      • If you’re above the PSA, you can avoid UK tax by using Premium Bonds or an ISA (Cash ISA or hold bonds/fixed income/etc. in a S&S ISA). You’ll still be subject to US tax, though.
      • You could also hold bonds/fixed income/money market/etc. in an IRA. Most practically this would be a Roth IRA, so that you can withdraw the contributions any time without penalty, although you can also use the “money is fungible” principle and sell equities in a taxable account to generate cash for spending and then sell the bonds/whatever to buy equities in an IRA – you’ve effectively taken the cash out of the IRA, just with a bit more shuffling around.
      • US Series I and Series EE bonds give you the option of deferring US tax until the bonds mature or you cash them out, or you can pay tax on an annual accrual basis. UK gilts work similarly at first glance, although they’re not one I’ve dug into deeply.
        • I don’t know for sure how the other country respects the deferment vs accrual option for bonds from the first country. For my Series EE bonds, I use the accrual basis for both my US and UK taxes, because trying to do them differently might make my head explode! (bad enough I do the accrual for two different tax calendars…). That’s one I can’t guarantee I’m doing right, but the interest is small enough I’m not going to sweat it – worst case, I’m paying HMRC slightly more and quite a few years earlier than they’d get paid otherwise.

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