Do You Really Need to Keep Six Months in Savings?
If you talk to financial planners they will always recommend keeping some of your savings liquid, i.e. in cash. Over and over I’ve heard the phrase 3–6 months. If you happen to be a high wage earner or a super saver then these extensively trained professionals will actually push you to invest all your savings beyond that six month reserve in long term illiquid investments. I can only assume they believe that their clients are ‘leaving money on the table’ by not investing any excess beyond a comfortable buffer. Hearing it again while I was considering my own financial plan got me thinking as these things generally do. I thought about how complex our work environment is I realized 3–6 months may not be enough. It made me wonder: how much should you have saved?
As I said the drumbeat from the personal financial experts is that best practices are 3–6 months of savings. You can’t really blame them for adhering to this position. It’s well known that most Americans don’t save. A scary large percentage lives week to week and their savings plan for emergencies and even regular expenses like Christmas shopping is generally is built around the word ‘Visa’. That being said, technically most Americans aren’t professionals who are trained to think strategically. Now this isn’t a hard and fast rule where if you went and got a college degree or two you know how to manage money. Money is an emotional thing. I know plenty of professionals who don’t save. One in particular is an accountant friend of mine who is great with managing money, well unless it’s her own. She’s a disaster there. I don’t have the numbers on how many people with a college education keep a large savings buffer and how many there are who don’t have a degree yet still save assiduously but i’m sure that a venn diagram would say that more who are educated save. (create savers / high income / low income diagram) There is some evidence in that it’s well known that more education generally means higher incomes and it’s also well known that higher incomes tend to save more. But going back to the emotional component, I know many people with modest incomes and maintain over 100K in their bank account and many people who make hundreds of thousands per year and live paycheck to paycheck. So with all this emotion, with so few people savings, it’s reasonable to for our fiscal advisors to say that best practices are three to six months. If we then pretended that everyone had that three to six months then the big philosophical question becomes, are the best practices right?
Are the best practices right?
I’ve written and discussed at length how we live in an era of Just-in-Time employment. By default just in time means that there is going to be huge transition in the workforce. Economists love the fact that America’s economy allows for this flexibility, Individuals and companies are not the same, baring comprehensive social programs, empowering flexibility for the individual worker means having a massive savings account.
How much you need depends on how long you will be in between the ups and downs in job transitions. According to an article in the balance, a very rough rule of thumb for job searching is one month for every 10K in salary. The alignment to salary is because the more specialized the need of the job is, something that’s happening to almost every job out there, the more money will be offered to meet the demand. Realistically that means the more specialized the job seeker is, the more money they will demand. This information aligns roughly to what i’ve discovered. Average is about six months with the median professional income floating roughly around 40–70k a year. One thing to keep in mind is that this is an average. If your SUV needs a six thousand dollar engine, something that recently happened to a friend of mine, it doesn’t matter one iota to you if the ‘average’ engine replacement cost is three thousand dollars. The average for replacement vehicle engines are a lot like time in between jobs. The individuals that make up the average are all over the bell curve with extremes. You can’t just be prepared for the average, you need to be prepared if your point falls anywhere in that curve, even to the far left or right.
As an addendum to this, I would say you need more if you find yourself in a negative career spiral. A negative spiral means that one crappy job leads into another one. This type of trap is easy to fall into because the bad jobs are the ones that churn through the most people. I’ve had a few of these in my day. I remember blowing up at an HR rep who told me in my ‘exit interview’ that this is a high churn job. “Well why the &$%! didn’t you tell me that at the beginning? I would have never wasted six months of my life with this misery!!” I told them. So I went on the market and without a buffer, I took another job that paid the bills and I wasn’t able to be very picky. Not surprisingly that job stunk too. The same thing happens to hundreds of professionals.
This conversation mostly centers around the ‘loss of job’ emergency. But as I alluded to It goes up and down and regular life emergencies happen vis a vie the aforementioned major vehicle repair.
If you are married or in a deeply committed life partnership, it can help but can also be a liability. Marriage Can be a huge asset if your spouse is on the same page financially as you. Having a spouse who aligns to your financial values is very rare. If your fortunate to be in a financially healthy relationship and you are dealing with an emergency like a job loss or an unwarranted roof that needs replacing then It’s like cutting your loss in half if your spouse is working outside the home. Marriage is a double edged sword, it makes the good better but makes the bad worse. Marriage doubles your risk if he/she is a stay at home parent because of increased expenses of two parents working or, worse, if they are financially opposite of you.. A spouse that spends even when the income isn’t coming in can create problems bigger than bills.
Doing the Math
Obviously if i’m going to explore a question of how much savings do you really need, then i’m going to have to do some math. The first number I have to start with is job transitions, transitions that are accelerating every single year and show no signs of slowing down for the foreseeable future. Right now the average is staying on the job about four years. I’m going to stick to the averages for this part, but the average time on the job is a bell curve. There are still some people who do thirty plus years at the same job and some people who last about thirty weeks between jobs throughout their entire career. So what does the math look like? Well sticking just to the averages, then you need to save six months of salary for the down time over that period. If you are transitioning jobs every four years, and if it takes on average six months to get a new job that means you’ll have to save approximately 12.5% of gross wages or 20% of net. That’s just to make sure your life buffer meets your down periods and not other life emergencies that come along. Yes, it’s understood that there is unemployment and side jobs, but getting a new job is a job unto itself. There are actually additional expenses if your in the professional class and doing it correctly. Going to a convention is a great networking opportunity but they get very expensive very quickly if a company isn’t paying the bill. I know i’ve done it a few times. So that means that you want more than six months, maybe much more than six months. So how do you get there?
The first step I would suggest is to align savings to your financial strategy of choice. The benefit of the offensive strategy means less transitions that aren’t on your own terms because your always jumping ahead of the game. Your so into the game you rarely get knocked out. If your not willing to settle, then it may take longer because you are up the ladder of income. In this case, I would probably suggest a minimum of a year. Hopefully you’ll never have to use all of it because if your truly offensive then you’ll have lots of options.
Financially defense players have less financial needs when the inevitable transition happens. But it’s still a ratio, so the time frame measured is the same, but without any debt or house house payment that means there is much less money you need in reserve. Also, if you are lower end of the income scale, then it’s easier, on average, to find a job. I’d still shoot for a year in this case but a year of a financially defensive players reserve is probably a much smaller nut to bust than the one for the financially offense player.
If married or in some other form of legal partnership and you’ve worked out a good financial relationship with your partner, then one solution is to always be able to live on a single income easily. In this case i’d say the high end of the recommended solution is acceptable. Six months should be the minimum of cash you need. If you both work for the same organization or one of you is a big spender, then I’d go back up to a year of cash in the bank minimum.
Look to the experts: Using a business model
We are currently moving to a world where everybody is a contractor. This makes everybody a little business. Best practices for business are actually a year of operating revenue. Any good business person will tell you you want to be even stronger than that because the good ones will use their huge cash reserves to take advantage of market downturns. They can push the little guys out of business or take away market share when the tough times come, and the tough times always come. This reinforces the model of at least a year that I suggested.
So how much do you need? Looking at the numbers and taking best practices from business, I would say the ideal is between one and two years of household operating income. If you make 60K/year and after taxes, not counting healthcare because you’ll have to maintain that while on your break, your net is 3k a month, then your savings should be somewhere between 42K -84K plus whatever Cobra healthcare is going to cost you. That could be another 6–18K depending on what your healthcare cost is. So a good round number is going to be 1.5x your gross pay. I get how impossible that sounds. Most working professionals would literally have to spend the majority of their discretionary income for several years on their ‘savings’ and it would never end because the savings would get eaten up during any major job transition.
If you wanted savings fantasy-land, you’d need enough where you never have to work again or where years off your job is just a small dent in your savings. Looking at the above numbers, fantasy-land for an early or mid-career professional would be 300K in the bank and for a later career professional, it would be whatever the gap is between what they are earning and full retirement. Obviously unless you hit the lottery in business with stock options in an insanely growing company, have a hugely successful side business or get a massive inheritance, your odds of this happening are close to zero. That means we have to take a good look at what are reasonable rules thumb.
Things to keep in mind:
It’s not 3–6 months, in all cases six months is minimum only if you are in a financially healthy and seriously committed relationship. If this is the case then always, and I mean always be able to live on one income In all other cases ideal is one year.
Cash reserves should = 1.5 years of gross or a year of net take home plus enough to cover emergencies like broken cars transmissions, roofs having to be rebuilt, etc.. These things happen if you are in work, or out of work. I’m sure financial planners will cringe if you have this much money in liquid cash beyond the 6 months. I’m ok with investing more than the 6 months, but you should have a year of expenses plus extra for emergencies, and the other six months should be readily available cash with no penalties, for example, a Roth IRA, where you can pull the taxed principal without any penalty. Remember stocks go up and down so if you go in that direction then keep that Roth after tax contribution well above six months. I say this because if you need it due to a job loss related to an economic downturn, which is likely, than what you can pull is going to be much less than you put in. So at this point your reserve looks something like 6 months of cash and 2 years after tax contribution into your Roth.
Don’t be upset if you don’t have it.. Almost nobody does. But figure out a plan to get there, even if it takes twenty years. Hide one or two hundred bucks a month in an account that is auto drafted and nobody sees. Load that Roth up as much as you possibly can and still live.
I’ll admit that what i’m suggesting is tough. Saving so much, giving up so much to have huge buffers when things go bad, but think of what you get out of it. Imagine a world with no payments whatsoever, not even a mortgage, and enough cash to live for two years plus some put away for a new transmission or even a brand new car in an emergency. You’d be in a rarefied state, and it would change your thinking and your actions in life. Gone would be fear of losing your job and you could take bigger risks. Sometimes that even helps accelerate a career. At the very least it makes things more interesting. You may even get that career ticket on the space elevator because you weren’t afraid to do the things others were afraid to do, like piss people off to get the big task done.
Even if you were let go and you don’t ever get back to where you were from a career perspective you’ll have enough runway to get to where you need to be both emotionally and financially. The emotional part is bigger than the financial part in this because it takes years to realize that others may not perceive your value as much as you believe it should be. Time helps this and money allows for time.
Since we are talking about money, let me end by saying this: If you lose your job, or if another emergency happens, no matter what the total amount of cash is, having a buffer that will carry you over a year of life is priceless!
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