Why you don't need an emergency fund

Q: I know when you work you should have an emergency fund to cover about six months of your expenses. In retirement, how much emergency/contingency fund should I have?—Renuka

A: You’ve put an interesting twist on a common financial planning question, Renuka. I should start by saying that I’m not a big fan of the six-month emergency fund rule, at least in a traditional sense. I’ve heard six months of income as well as six months of expenses, but since most people spend almost everything, it’s more or less the same thing.

The median family income in Canada according to the 2011 census was $76,000. After tax, depending on province of residency, tax deductions and credits and how that income is split between two spouses, the median family takes home about $60,000. A six-month emergency might therefore be about $25,000.

If a family keeps $25,000 in cash earning 1% over a period of 25 years—if they can even scrape it together in the first place—they might pay an incremental $27,344 in interest if they’re simultaneously carrying debt at 4%. What about missed tax deductions on RRSP contributions? Missed Canada Education Savings Grants on RESP contributions? Or the opportunity cost of only earning 1% instead of a higher rate of return if that money was invested in a balanced investment portfolio?

The point is that sitting eternally on cash is a poor strategy. And for most Canadians who have debt, unused RRSP contribution room and other missed financial planning opportunities, sitting on a six-month cash reserve is a losing proposition. Only the banks win, since they’re borrowing from you at 1% (the savings account interest rate) and lending it back to you at a higher rate (your mortgage, line of credit, loan or credit card rate).

I’m all for having the potential of covering 6 months of expenses in the event of an emergency. But I’d rather someone be able to do so through a combination of modest savings and ideally, a low-interest rate debt facility like a secured line of credit.

In retirement, the thing is, Renuka, all you have is a contingency fund. Oxford defines contingency as “a future event or circumstance that is possible but cannot be predicted with certainty.” Thus is the nature of retirement.

The most common contingency that one might protect with an emergency fund during working years is a job loss, so it’s an income or cash flow concern. In retirement, your income is typically a combination of fixed (pensions) and variable (investments) sources. So by holding too big a cash position, you actually decrease your income and increase your risk of not having enough retirement income for enough years.

I’d say the biggest contingency in retirement is life expectancy. And the best two ways you can protect against living too long are spending modestly and earning a higher rate of return on your investments. So I think you need to be careful about having too big a cash drag on your investments as it will bring down your portfolio returns.

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Now, if your overall asset allocation—determined with your investment adviser or on your own in building your portfolio—calls for a certain allocation to cash, that’s another thing.

But to carve off money and remove it from your investments to specifically sit in cash, I’d say, ideally, is something to be avoided.

If your investments and pensions don’t generate enough monthly cash flow, you may need to maintain a cash balance that you replenish by cashing investments in order to ensure that you can maintain your income stream. I’d keep it as efficient as possible, in an ideal world, so that your money is put to work as long as possible.

This may mean staggering GIC or bond maturities to replenish cash. Or it may mean using a short-term bond fund or exchange-traded fund that you pull from as cash is needed. There are other strategies that go beyond the space we have here.

If you have more than enough income and investments to fund your retirement and keeping a cash cushion is a comfort thing, it may not be the most efficient way to do things – but there may be a non-financial return on your cash in the form of peace of mind.

Doing your own budgeting or working with a financial planner who can create a retirement plan for you can help you determine how hard you need your money working. In other words, what rate of return do you actually need on your investments? If you need a modest to high rate of return, consider keeping your cash holdings low while staying reasonably fully invested.

Any rule of thumb number like three months or six months has little empirical merit. It’s not a number you can “calculate.”

If you’re lucky enough to likely have more money than you need in order to fund your retirement, consider a cash cushion that balances peace of mind for you and optimizing your estate for your ultimate beneficiaries.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products.

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.