Total Pageviews

Monday, October 22, 2012

Call It an Uncertainty Fund, Not an Emergency Fund

napkinThe Behavior Gap,” was published this year. His sketches are archived on the Bucks blog. A few weeks ago I wrote about the challenges of managing a lumpy income-one that varies a lot from month to month or year to year.

With this shift to lumpy incomes comes the increasing need to pay attention to what my friend Manisha Thakor, a financial adviser and author, calls an “uncertainty fund.”

We used to call this thing an emergency fund or a rainy day fund, but the basic idea is this: You set aside a bunch of cash to see you through emergencies like a job loss or huge medical bills.

There are a lot of old rules floating around about emergency funds. The most common one says you need to save between three and six months of your income to really be safe. But there are few problems with that rule.

  • It's arbitrary. Why is three months or six months right for everyone?
  • Who has that kind of money anyway?
  • Where should collecting that pile of money land on the priority list?

Do you stop building your retirement account for a year or two or three to build up your uncertainty fund? Should you pay off your credit card debt first? What about saving for your kids' college tuition?

So the old rules of thumb are inadequate for most of us, yet the need for an uncertainty fund is rising. Now what should you do?

In this case, I'm not going to try to replace an old, arbitrary rule with a new one. I suggest you ask yourself two crucial questions to decide how to solve your own uncertainty fund problem.

1. What is the level of uncertainty in my life?

To decide how much risk you can afford to take with your finances, consider the risk you're taking with your human capital. If you're on a risky career path, you might need your uncertainty fund to be a lot bigger.

We used to think of risky careers as those that crazy entrepreneurs pursue. But now, for the first time, you're at risk even if you have the kind of steady job we used to think was secure for life.

I have a lot of friends in Las Vegas who are dentists. I don't know of any of them who went into dentistry out of a spirit of entrepreneurial risk-taking. They went into it because it was stable.

But then they woke up one day and found that the economy had crashed. The real estate market imploded, people were moving away and my friends worried about losing their practices. These guys are dentists - they didn't sign up for all of this. They signed up for doing the same thing for 30 years. They didn't really do anything wrong. It's just that the landscape shifted. So examine whether that same shifting landscape has put your own career in greater uncertainty, or whet her it might before too long.

Consider other potential financial uncertainties too. What do you worry about? Maybe you fear that your elderly parents might become dependent on you or your children might have to move back in with you after college.

2. How can I deal with it?

Now think about the resources available to you if you lost your job, had to support an aging parent or needed to pay off a huge hospital bill.

Some of us may decide the best approach is to save as much as we can in an old-fashioned rainy day fund. But if money is so tight that saving isn't a realistic option, you have to get creative.

  • Do you have home equity you can tap? Consider getting a line of credit now to serve as your safety net in case of emergencies.
  • Can you borrow against the money in your 401(k) plan? Would you want to do that?
  • If your spouse doesn't work, could he or she get a job?
  • Do you have decent disability insurance?
  • Do yo u have a fallback plan if you lost your job? Maybe you used to wait tables or paint houses and might be able to pick up some work on the side while you look for something better.

The point is that an uncertainty fund doesn't have to be $100,000 parked in a money market fund. But it's important to have some kind of plan in place that will offer at least some cushion against financial blows.

What creative ways have you discovered to add to your uncertainty fund?