What We Can Learn From 2012

March 13, 2013

Last week we released our 2012 Year in Review research, and there were several troubling statistics that came out of the report.  For starters, only 51% of employees reported having an emergency fund, which means there are 49% that are vulnerable to a financial setback should some unexpected expense come along.  Another troubling statistic was an increase in the percentage of employees that reported taking money out of their 401(k) as either a loan or hardship withdrawal.  Such early distributions can greatly impact if and when these employees will be able to retire.  As a result of sending out our research, we received the following three questions from a reporter:

1. What exactly is an emergency fund?
2. What is the real cost of taking money out of retirement savings?
3. Why when emergencies seem commonplace is it hard for people to be prepared?

The nature of these questions seemed important enough to share with you the answers.

What exactly is an emergency fund?

An emergency fund is money earmarked for unexpected expenses.  By definition, these are expenses that are not accounted for in a budget.  They include things like a deductible on an insurance policy, an unplanned trip across the country (or world), a medical or health related expense, or the loss of income due to a job loss, reduced hours, or the vacancy of rental property.

A basic emergency fund might be a simple savings account at a bank or credit union.  It could be in a money market account, a certificate of deposit, or some other safe, liquid (meaning it can easily be converted into cash) type of account.  Some investors consider their Roth IRA as a potential emergency fund since principal can be removed without tax or penalty at any time.

Some even use investments other than cash (e.g. mutual funds, stocks) for their emergency fund, but this can be problematic.  For example, imagine losing your job after having the stock market fall by 40% and then having to sell your investments at a loss in order to provide enough cash while you look for another job.  For this reason, most financial planners suggest keeping 6 to 12 months of expenses in conservative investments such as the CDs or money market accounts I mentioned earlier.

What is the real cost of taking money out of retirement savings?

The real cost of taking money out of your 401(k) depends on a number of factors, including how old you are, how you access it (i.e. loan or hardship), and how your funds are invested.  For example, if a 35-year old has to take $10,000 out of their retirement account as a hardship withdrawal, not only will they have to pay taxes and a 10% penalty ($1,000 in this example), but they would lose over $100,000 in account value by age 65 (assuming an 8% rate of return).  If you are interested in calculating the cost of borrowing from your 401(k), check out this cost estimator from bankrate.com: http://www.bankrate.com/calculators/retirement/borrow-from-401k-calculator.aspx.  In the end, it is really a question of opportunity cost and the longer you have until retirement, in general the more it will cost you to take money out of your retirement account.

Why when emergencies seem commonplace is it hard for people to be prepared?

For starters, emergencies should never be commonplace.  An emergency should be something unexpected, yet people often use their “emergency” savings for things like vacations and car repairs.  These are expenses that should be incorporated into a regular budget, not something paid from an emergency fund.

Also, people fall into the habit of spending money first and then trying to save what is left over, rather than “paying themselves first” through some form of automatic savings.  As a result, the emergency fund is something that never gets funded to the level it should. It would be better to have money automatically transferred from a checking account to a savings account or splitting up a direct deposit to separate accounts as a way to build the emergency fund over time.

Speaking of separate accounts, another reason people have trouble building up their emergency fund is because they have easy access to it.  What happens to some people is they keep their emergency fund at the same bank or credit union as their checking account and when they notice the checking account balance getting low, they transfer money from their savings account into it, rather than choosing not to spend money and to wait until their next paycheck.  On the subject of paychecks, some people have a bad habit of living up to their paycheck, rather than choosing to live below their paycheck so that they can set some money aside.  Most financial professionals recommend saving at least 10% of pay, yet how many people do you know choose to live on 90% or less of their income?

In the end, it really is a matter of behavior.  People need to develop a behavior of saving and not of spending.  If they do, perhaps we will see more saying “yes” to the emergency fund and “no” to the retirement plan withdrawals when we do our year in review for 2013.