Emergency Fund

One of the many lessons learned from the Great Recession is that emergency funds should be available to all American households.  Not only was unemployment high, many individuals struggled for months to find a job.  Unfortunately, there are many myths about rainy day funds.  Let's take a closer look at unemployment data, and figure out how much money is really needed.

In this publication, we're going to be talking about emergency funds.  As part of that discussion, we'll first talk about family income versus expenses, and "rules of thumb" that can be misleading.  Next, we'll take a close look at some data published by several U.S. government agencies, and turn that data into insights about the required size of emergency funds.  Finally, we'll provide you with a link to our online emergency fund calculator.

About Emergency Funds

Also known as emergency reserve, rainy day funds, and rainy day reserve, these terms are used to describe assets that will be used when income is disrupted or discontinued.  Households that have taken the initiative to set aside these funds typically do so as protection against financial emergencies such as unemployment.

While unemployment can certainly be a longer-term financial burden, emergency funds can also be used to pay home repairs, medical expenses, automobile repairs, and other unexpected expenses.  Once established, an emergency fund should not be used to pay for a vacation or buy a car.

Building an Emergency Fund

One of the common myths about emergency funds has to do with the size of the fund.  The traditional emergency fund rule of thumb was to save three to six months of income.  A logical person cannot justify an emergency fund rule of thumb that involves income, since the fund is used to pay for expenses.  From this point forward, we'll be talking expenses, and not income.

Identify Essential Monthly Expenses

Think of essential expenses as the last expenses you would ever think about eliminating.  For example, if you have a secured loan such as a mortgage or car loan, then you need to make those monthly payments.  Groceries are another example of essential household expenses:  you need to eat.

Discretionary expenses are the expenses that you could do without, or give up, without too much pain.  Discretionary expenses include entertainment, recreation, vacations, subscriptions and luxury items.

Examples of essential expenses:

• Living Expenses - includes mortgage and rent payments, real estate or property taxes, homeowner's insurance premiums, as well as household repairs.
• Travel Expenses - includes monthly car loan or lease payments, car insurance premiums, gasoline or fuel costs, and car repairs.
• Personal Expenses - includes personal and / or student loans, life insurance premiums, medical as well as dental insurance payments.
• Household Expenses - includes household essential operating costs such as electricity, natural gas, water, telephone / cellular phones, internet access, sewage, and waste disposal fees.  Also includes food purchases, as well as essential credit card payments.

Unemployment and Emergency Funds

While an emergency fund can be used for several types of financial tragedies, the loss of household income often places the greatest burden on a family's finances.  That's the primary reason the size of a fund should be based on the length of time a person is likely to remain unemployed.

Fortunately, unemployment statistics are frequently published by several U.S. government agencies.  Using this data removes most of the objectivity from the emergency fund calculation.  The data can also help dispel some myths concerning the relationship between income and unemployment duration.

Unemployment Myth #1 - Age and Unemployment

This first myth goes something like this:  The older you are, the longer it takes to find a job.  According to a study published by the U.S. Census Bureau published in March 2006, the median duration of unemployment in the group studied was 2.4 months.  The shortest duration was 1.8 months for 16-to-19-year-olds, while the longest was 3.1 months for people aged 45 to 54.

While there certainly is a difference between these two groups, the difference is a little over one month.  That's not going to make a big difference when calculating our emergency fund.  So we're going to dispel the myth that age needs to be considered when calculating an emergency fund.

Unemployment Myth #2 - Income and Unemployment

The second myth goes something like this:  the more money you make, the longer it takes to find a job.  It's been widely demonstrated that income rises as the level of education increases.  So if the above myth were true, we'd expect the median duration of unemployment to rise with educational attainment.

Fortunately, the Bureau of Labor Statistics measures unemployment duration by education.  The table below contains the average duration of unemployment by education from the year 2006 through the first six months of 2010.

Duration of Unemployment (Months)

In each of the years in this table, the pattern is the same.  The higher the education of the individual, the easier it is to find a job.  This data clearly dispels the myth that higher income individuals have a harder time finding a job.

So what do we know so far?

• Income has nothing to do with the size of an emergency fund.
• Age, and therefore the number of years in the workforce, has only a small influence on the duration of unemployment.
• Individuals that have a college degree will find a new job faster than individuals with lesser degrees.

Any calculation of an emergency fund that uses factors such as income, salary, or the years of employment is clearly wrong and will provide illogical results.  There are only two factors needed to project the appropriate size of an emergency fund:  essential expenses and unemployment duration.

Unemployment Duration Projections

Let's look at some of the unemployment data gathered by the Department of Labor (Bureau of Labor Statistics).  We'll use that data to determine the duration of unemployment, which is the second value we'll use to calculate the size of an emergency fund.

The Bureau of Labor Statistics has information concerning the duration of unemployment going back to 1962.  In this exercise, we're going to use data from 2005 through 2009.

Duration of Unemployment

The above table gives us two types of information.  The first is the median duration of unemployment.  As a reminder, the median is the midpoint in the data.  For example, in 2009 we can see that 50% of unemployed individuals were looking for a job for 15.1 weeks and 50% of the unemployed that year were looking for more than 15.1 weeks (around 3.5 months).

The second set of data in the table is the percentage of unemployed for each duration period.  For example, 32% of individuals took more than 27 weeks (around 6 months) to find a job back in 2009.

The Great Recession was an extraordinary time in terms of unemployment.  But if we were to look at the pattern in the above table, we can draw a generalization:

• There is a 50% chance that the duration of unemployment will be less than 9 weeks (around 2.5 months).  Therefore, the minimum emergency fund should be equivalent to three months of essential expenses.
• There is an 80% chance that the duration of unemployment will be less than 27 weeks (around 6 months).  Therefore, the optimal emergency fund should be equivalent to six months of essential expenses.

Emergency Fund Calculator

You can run through some "what if" scenarios using our online emergency fund calculator.  That tool was built based on the data and methodology described in this publication.  The calculator allows you to input your essential expenses and provides you with an estimate of both the minimum as well as optimum size of your emergency fund.

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