It’s Time to Start Putting Money Aside to Grow an Emergency Fund

Roughly 42 million Americans live paycheck to paycheck, or so says a recent survey commissioned by Automatic Data Processing, a New York-based payroll service. If one paycheck were late, 60% of respondents said they’d have to cut back on at least one important household expense such as buying groceries or paying rent or utility bills, the survey found.

Although ADP says this underscores the need for efficient payroll processing--which, big surprise, happens to be the business ADP is in--financial planners counter that this underscores the need for every American to have an emergency fund. Yet emergency savings have fallen by the wayside in the last decade as Americans have flocked to the better-performing stock market.

“It’s things like this that people overlook,” says Peg Downey, a certified financial planner with Money Plans in Silver Spring, Md. “[Emergency funds] seem too insignificant or boring, but they are absolutely the key to having a sound financial life.”

Would your life be decimated by a financial emergency? It’s not difficult to figure out.

“Pretend that tomorrow, for whatever reason, you are not going to be able to work for six months and the stock market is down 15%,” suggests Brent Kessel, a certified financial planner with Abacus Wealth Management in Santa Monica. “What would sustain you? Do you have passive income? Would you be able to collect insurance? Do you have bonds that you could sell without taking much of a loss?”

If you feel you could handle a sustained period of unemployment without undue pain or stress, you probably have enough emergency savings, he says. If you couldn’t, you need to ask yourself how much you need, how to accumulate it and how to invest this money to keep it available, yet earning a decent net return.

Most people need three to six months of living expenses in emergency savings. (Living expenses generally amount to about half of your gross income, because the other half of what you earn usually gets eaten up in taxes, discretionary spending and savings.) But some people could use substantially more, others substantially less.

The actual amount you need hinges on just how likely you are to suffer sudden economic upheaval and what type of emergency is most likely to strike. Although the very nature of “emergency” indicates something surprising and unplanned, in reality, you can handicap your chance of financial emergency and even come fairly close to hitting the approximate dollar value of the hurt.

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The reason is fairly simple. Most people have some economic safety nets, ranging from life, health and property insurance to disability and unemployment coverage. Putting a number on how much emergency money you need, consequently, boils down to figuring just how much cash would come out of your pocket before one of these safety nets kicked in.

If you don’t have any safety nets--no insurance of any type or accommodating relatives who would take you in if you couldn’t pay your rent--your need for emergency savings is much bigger and more urgent than it would be if you were well-insured and greatly loved by someone with a guest room.

Kessel advises self-employed people and commission-based sales people to consider socking away as much as a year’s worth of living expenses to handle prolonged market slumps. Downey thinks half that would do.

“If you are self-employed, you ought to have six months,” she says. “If you are just out of school and you have folks who are willing to help you out, you might only need one month. But, for the average American worker, probably three months could do it.”

Or, you can simply play a game of “what if,” says Edward O’Hara, certified financial planner with Capital Asset Management Services in Silver Spring, Md.

Contemplate the events that could have the most devastating economic impact. Is it the loss of a spouse; the loss of a job; a medical emergency; or even just a big car repair? In the event you suffered one of these catastrophes, do you have insurance to help mitigate the economic damage?

If so, how much of a gap is there between what you’d need and what you’d have? Do you have money in taxable savings accounts--as opposed to retirement accounts, where you’d suffer a huge tax hit for early withdrawals--that could be tapped?

Planners say another economic, and personal, catastrophe has become increasingly common: Your out-of-town parent is ill and needs you to drop everything and help out for a few months. That means losing some income while taking a leave from work and incurring a variety of other expenses, such as last-minute plane fares, Kessel notes.

If reading this depressing list of possibilities leaves you certain your emergency stockpile needs shoring up, call your bank or broker and set up an automatic savings plan. These plans, offered by nearly every major financial institution, deduct money from either your paycheck or your checking account every month. Once it’s set up, you can forget about it until you’ve saved enough and can cut off the contributions.

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Don’t worry too much about the rate of return on your emergency savings, Downey says. Money market accounts and bank certificates of deposit pay about 6% today. However, if you get only 5% on your $5,000 emergency fund, you’re giving up just $50 annually. If you figure the after-tax cost, it’s not enough to worry about, she says.

“For most people, the convenience is going to be more important than the rate of return,” she says. “You need to make sure that your emergency money is accessible.”

What you don’t want to do, of course, is put the money in a simple bank savings account, with annual interest rates averaging 2% these days. Nor do you do the opposite extreme and tie up your rainy-day fund in a one-year certificate of deposit just to pick up a few extra points of return.

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Rainy-Day Fund

Financial planners say most people need enough money set aside to cover three to six months’ worth of expenses in case of financial crisis. Some people need more, others need less. Where do you fall?

You need comparatively less emergency money if....

* You have lots of available borrowing power on credit cards.

* You have plenty of insurance--life, health and disability.

* You have friends or family who would bail you out or let you move into their guest room.

* You have a stable job in a growing industry.

* You have other savings and investments available.

You need comparatively more if....

* You’re a temporary employee in a volatile industry.

* You have considerably more debt than investments.

* Your only insurance is on your car.

* Speaking of that junker--it might be heading for a major repair job.

Source: Times research

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Times staff writer Kathy M. Kristof, author of Investing 101 (Bloomberg, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St. 90012, or e-mail kathy.kristof@latimes.com. For past Personal Finance columns visit The Times’ Web site at http://161.35.110.226/perfin.