Cash at Home

A Micro Rainy Day Fund

Cash at Home

This week, my students are exploring reserve funds, their advantages, and costs. Coincidentally, Anne Tergeson and Jeremy Olshan wrote a piece for the Wall Street Journal with the hilarious title, “The Right Amount of Cash to Keep at Home for Emergencies. Hint: Not $480,000,” poking at the finding of a substantial amount on reserve at the Menendez household, while asking the more serious question about disaster response. Tergeson and Olshan sought to answer the question about how much cash, literally cash, a household should store for when disaster strikes. It is important to consider what happens when the lights go out, communications are impaired, repairs are needed, and alternatives for short-term food and shelter are not present. Economics was brought into their writing: “…advisers say money should be collecting interest, not dust at the back of your sock drawer.” A safe helps with the risk of peril loss, but cash lying around anywhere has a cost.

In personal finance economics, cash lying around is an opportunity foregone, and we are on board with households holding some disaster relief funds in what can be described as a micro-rainy day fund. The cash-for-disaster solution is a smaller-scale example of reserve funding. Tergeson and Olshan tickled the subject in their setup to their article, even calling upon the Bible, “…it is personal-finance gospel to save an emergency fund of three to six months of expenses.” Sorry, I don’t have a citation about whether it was in Matthew, Mark, Luke, or John. I will ask my daughter-in-law, who was on the Bible team at her high school. Maybe a subscriber can help us out.

But, there is that nettlesome, brain-is-logged-out, boring rule of thumb offered by the experts who don’t carefully consider the risk and cost of a reserve fund strategy in financial planning. Rainy days, emergencies, and reserve funds are different names for the same vehicle, and their interest became acute during the pandemic. Even if the federal government came to the rescue, would a household have enough money to stay afloat? Today, we will step aside from the topic of households handling the risk of loss and the incentives created when the government routinely behaves as an insurer of last resort. Instead, today’s topic is the correct target for a reserve fund. What should that be?

Reserve funds must be considered as part of any economics-based financial planning and the costs of higher and higher amounts on reserve can be discovered through exploration of their living standard effects.

There is science behind the effect on the household’s living standard if money is held on reserve for two, six, or 18 months; that can be quantified in practice. There is no science behind an advisor’s recommendation for two, six, or 18 months of funds dedicated to an emergency without measuring a household’s expected lifetime living standard and bringing risk to bear. The choices for green energy engineer Jayson Gentry were outlined in a prior article.

Constants across households hint at a one-size-fits-all approach to financial planning surrounding reserve funds. At the moment of financial dislocation, the social security benefit structure applies; hard assets like cars can be sold for cash, and creditors can be given a heads-up about the potential for financial headwinds. Every household can search for job opportunities across the U.S. and evaluate the cost-of-living benefits of moving. Still, advice centered on three to six months of income should be available for an emergency is unlikely to provide the best fit.

The key point is any reserve fund recommendation must be household-specific.

Household members have zones of comfort and tolerance for risk that make them unique. Equity in a home, retirement account values, and being okay with a certain amount of newfound leisure and child responsibilities shade differences across households. A household’s solution for reserve fund size begins with its current optimized living standard without a reserve fund. This will establish the baseline living standard. Then, the household (or planner) can explore different reserve funding levels (one month, two months, three months,…., twelve months) and see how the living standard changes for each reserve funding level. In the business school, we call this approach a “sensitivity analysis,” where a change in current living standard is measured when a certain amount increases the targeted reserve fund level. A household with no funds on reserve might have an expected living standard this year of $80,000. For example, placing $40,000 in reserve may decrease today’s living standard to $75,000. Not much of a change for the security afforded by a rainy day fund. While allocating today a chunk of financial assets to be “on reserve” is money taken off the table for living, the change in annual living standard is more minor than might be expected because the effect is spread over the remaining expected lifetimes of the household adults. The sensitivity analysis can then continue. If I allocate $60,000 to be on reserve, how much lower is my annual, sustainable living standard? And so forth. The approach creates a menu of expected living standards and associated reserve fund levels from which household members can choose their preferred pair.

The lesson is that numbers informed by integrating life-cycle planning and household preferences provide a better fit than a straightforward standard. Solid planning should be the rule of thumb.