Panic Not!
Breathe then plan for a financial crisis
Life turns when a child enters your life. Camille and Paul Du Bois are in the midst of it. New responsibilities, figuring it out as they go, and an immeasurable number of new trade-offs because activities once loved fit differently when Ivy comes first. Weekend time with the guys and after-work, happy hours with the other “team members” require a new evaluation. Ivy’s needs leave no choice: attention, time, and money funnel toward a new line item in the Du Bois household’s economy.
The financial risk to the household’s living standard was always there, but it is more apparent when a family grows. “It isn’t just us anymore.” One of those new responsibilities hits the parents' brains during a sleepless night of crying, feeding, and changing: “We need a plan. What if…”
Today, the what-if solution we consider is a rainy-day fund. “You should have a rainy day fund” is a common, often scolding phrase of personal finance advice that deserves serious attention.
Which Would You Choose?
Let’s start at the end and work to the beginning.
Make your choice among the three financial choices below using data for the DuBois household.
Choice 1: Do not explicitly save for a rainy day.
Choice 2: Set aside funds over 3 years to create a rainy day fund equal to 6 months of after-tax income.
Choice 3: Set aside funds over 5 years to create a rainy day fund equal to 6 months of after-tax income.
To help you decide, here is how the Du Bois household finances change
For Choice 1: The living standard next year is $204,624.
For Choice 2: The living standard next year is $193,044; over the family’s lifetime, the living standard ⬇ by $291,343.
For Choice 3: The living standard next year is $193,377; over the family’s lifetime, the living standard ⬇ by $273,673.
It is important to note that the living standard results depend, in general, on the household's makeup, including the ages and longevity of the adults, income level and associated taxes, and wealth.
The choice outcomes show a sneaky living standard effect. The rate at which money is saved into a rainy day fund and the accumulation goal of the fund have measurable short and long-term effects. Personal taste drives the best solution in most cases. You may think, “Either rainy day fund choice costs me upwards of $300k, forget it.” Others may think, “I want a rainy day fund. Choice 2 doesn’t cost me much in the near-term, and I get the money set aside quickly.”
Truly, there is no correct answer. The solution is a measurable balance that evaluates the trade-offs.
Rainy day funds are not for everybody or every household
An emergency fund, reserve fund, or rainy-day fund is the catch-all backup plan when a catastrophe hits: unemployment, a house fire, an uninsured broken water pipe, or a disabling accident. A rainy-day fund buys time to repair, rebuild, reorder, and continue to pay the bills.
What amount of money is appropriate to handle family needs when an uninsured event triggers a budget crisis? On the one hand, money set aside changes the question, “How will we pay our bills?” to a statement that affirms control: “We have the rainy day fund to pay our bills.” On the other hand, setting aside funds guarantees lower short-term living standards, which could be spent on different needs. It comes with an investing opportunity cost because the rainy day monies need to be allocated to safe financial assets.
Rainy day funds should not be invested in stocks that impose additional risk. A stock market swing shouldn’t touch a rainy day fund’s value.
The Du Bois case is a good example of the process.
The Du Bois Household
Baton Rouge, Louisiana, is a university town northwest of New Orleans and the city where Camille and Paul first met. Paul describes himself as a “Cajun,” a local boy who returned home to work for an oil and gas firm after receiving his chemical engineering degree from Rice University in Houston. Camille is an associate professor of chemistry at LSU. She received her Ph.D. in chemistry from Northwestern ten years ago, then made the trek from Evanston to teach and conduct research surrounding hazardous waste mitigation. Camille’s job comes with tenure and financial security. Paul’s job pays more, but could go poof in a nanosecond because his work life doesn’t exist in an ivory tower. Both 40 years old today, Camille and Paul met at a campus seminar five years ago and have been married for three years. New daughter Ivy was born two months ago.
There is a money storyline tied to this background. A two-income household, two employer-sponsored retirement plans, some credit card debt, a home mortgage, and future educational expenses.
The most relevant financial details:
Camille earns $150k, and Paul earns $185k. They are both projected to earn 1% real income increases and have a target retirement age of 67.
Both Camille and Paul have defined-contribution retirement plans through their employers. Paul contributes 5% of his salary, and his employer contributes 2.5%. Camille contributes 5% of her salary, and her employer is more generous, contributing an additional 8%.
One joint bank checking account has a balance of $65k, a joint brokerage account has $95k in market value, $45k is sitting in cash, and $50k is invested in the U.S. total stock index fund.
The Du Bois home is valued at $950k, and the mortgage debt is $450k. The monthly payment is $2,450, and the mortgage has 26 years remaining.
Given family history, prospects for longevity are very good. We assume a max age of 95 for both Camille and Paul. The implication is 28 years of retirement after 27 more years of employment.
Using an economics-based planning solution, next year’s cap spending is $204,624.
Complex mathematics is involved in determining this number. I use MaxiFi Planner for the calculation. Next year’s cap is $204,624, and all future years' caps are estimated based on the Du Bois’ ages, longevity, and financial characteristics.
In economics-based financial planning, the number is their highest living standard next year. Essentially, it informs how much to spend. The extent to which the actual income is higher or lower determines the amount of next year’s savings. Thought of another way, $204,624 is the amount they can afford after paying for housing, retirement contributions, and taxes.
Housing costs include the mortgage, insurance, and property taxes. Retirement contributions are the sum of Camille and Paul’s contributions to their respective retirement plans. Taxes include U.S. federal income tax, Louisiana state income tax, and U.S. Social Security taxes.
The “special sauce” is the discretionary spending total. Camille and Paul choose how to spend next year, and $204,624 serves as the cap. For their lifestyle to be sustainable to their max age, all other bills, such as childcare, education funds, utility bills, cell phone charges, food bills, and spending for fun, must not exceed $204,624.
For comparison, here are the best budget numbers for Choices 1 and 2 above,
Put yourself in the Du Bois’ shoes. Which choice would you select?
Share a comment.
Moving Your Rainy Day Planning Forward
If I can help, let’s schedule a free 15-minute call via my Teach:able site.
My approach to helping you determine your best rainy day fund choice includes the following steps,
Create the living standard base plan.
Arrive at a rainy day fund goal amount as an initial target, for example, a rainy day fund should be able to replace 6 (or 9 or 12) months of income. I recommend two other replacement choices to get some differentiation of the costs and benefits of a rainy day fund.
Determine a preference for periodic emergency fund deposits through dedicated periodic savings, earmarking existing financial assets, or both.
Answer the question: Which optimal living standard trade-off is most acceptable? If not, play what-if again. If the answer is yes, then the household has its optimal financial plan with a rainy day fund objective! If none exists, evaluate another target.