Chasing yield

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Brandi F on Dollar Stretcher asked an excellent question on the “Money Rules to Break” post:

I’ve always wondered if it was prudent for military members to keep a smaller emergency fund, given their job security and health care. I personally keep the traditional 3-6 months of expenses in my emergency fund for a few reasons: 1) if I separate early for some reason I’d have to repay my re-enlistment bonus, 2) when I deploy, I use the money in my emergency fund to maximize contributions to the Savings Deposit Program as soon as I’m eligible, and 3) it just makes me sleep better at night. But it does pain me to see my emergency fund earn a piddly 1%, and honestly I’ve never heard anyone make a military-specific recommendation about the size of the emergency fund. I’m looking forward to your blog post on this!

Thanks, Brandi.  Let’s tackle a few of the sound-bite misconceptions.

First, exactly how much does “3-6 months’ expenses” really mean? Hopefully “a month’s expenses” is not an entire month’s pay (or more!). Even if you’re only loosely tracking your expenses, advisers like Liz Weston and Elizabeth Warren recommend keeping “mandatory spending” below 50% of your after-tax pay. If you’re following that guideline then your emergency fund could be as small as 1-2 months’ after-tax pay.

If you keep a detailed budget then match your emergency fund to it. Concentrate only on the “have to” expenses like housing, food, childcare, insurance, and (if you’re unemployed) job-seeking expenses. Stop saving for retirement, stop saving for the college fund, and stop spending on anything else that’s not absolutely necessary to keep you safe & healthy. Set aside 3-6 months’ worth of those expenses.

If you’ve been saving for a few years then you might have substantial investment income available to bridge an emergency expense. I wouldn’t raid a retirement account (let alone pay penalties) or take a bite out of the principal of a taxable account. However, you may have regular interest/dividend income (from stocks & bonds as well as CDs and savings accounts) that could be diverted to your checking account for a month or two. That would also reduce the amount of cash needed to support 3-6 months’ expenses.

Second, anyone planning to be in the military for a while has more income reliability than many Americans. Even a forced resignation (due to a drawdown or some other reason) will come with several months of warning. Instead of keeping 3-6 months’ expenses in cash, have a plan to save it from your final few paychecks. This type of plan requires an extraordinary amount of discipline and will almost certainly cross the line from frugality to deprivation. However, if you have several months to prepare for the “emergency” then you’ll be able to reduce your expenses (while you’re still getting paid) and build up the cash reserves before your last paycheck.

Finally, when you expect to receive a steady paycheck then would you even need an emergency fund? That’s debatable. If you have to spend $800 on vehicle repairs then you could put that expense on a credit card and try to save enough to pay it off by the next statement’s due date. The mechanic might even be willing to work out a multi-month payment plan (especially if a family’s servicemember is deployed). If you had to replace the vehicle then that could cause significant financial problems. (Unless you’ve been setting aside money for an eventual vehicle replacement! But that’s a topic for another post.) You might only have a portion of the money saved for the replacement, but maybe you’d be able to find a beat-up bargain on Craigslist or get a used-car loan or make do with some other kind of transportation. In an extreme case you might even be able to appeal to your chain of command for a month or two of advance pay, although you may not care to call this sort of attention to yourself.

In the situations you point out, Brandi, there might be more flexibility. Of course if it makes you sleep better at night to keep some or all of your re-enlistment bonus in a cash account, then that’s what you should do. However, if you had to separate early then you might be able to negotiate a repayment plan or even defer it until you have steady income. That discretion might not come from the pay clerk at your personnel office but the base legal office would be all too familiar with the process.

Although the bare-bones expenses can be covered with one of the above methods, it’s important to still sleep well at night. There’s only a small difference between the detailed analysis that you need a fund of $823.47, and the decision to save $1000. The extra margin of safety might make a huge psychological difference.

What about our service’s relief organizations? What about a low-interest short-term loan from the Navy & Marine Corps Relief Society (or your service’s equivalent)? Sadly, I’ve never seen this happen. Most of their (very limited) funds are devoted toward keeping service members (and their families) from going homeless or hungry, and then to helping them get out of severe personal debt. You may only get their support if you’re in those categories, and again you may not want to call your command’s attention to this route. However, you could always call them and ask for advice.  If anyone has had a better experience then please share it in the comments!

Now that the size of the emergency fund has been decided, then where should it go?

First, it doesn’t have to be totally liquid. You’re not going to need to carry $1000 cash in your wallet to pay a plumber. You’ll probably cover an emergency bill with a credit card (or even a cash advance on one) and then start moving money around to be ready to pay off the debt. If you’re a homeowner then you might write a check from a home equity line of credit. Even if you’re paying cash, you’ll probably start with a deposit and follow up with the rest of the money in a few days. That gives you a chance to reach your emergency fund on the next business day, and possibly as long as a month.

As Brandi has pointed out, the interest rates on checkings & savings accounts just aren’t going to make anyone feel good about having an emergency fund. However, it’s not wise to risk the loss of principal by investing the fund in bonds, let alone stocks. The best way to avoid the loss of principal is to invest in federally-insured CDs or inflation-protected I bonds.

It’s extremely tempting to chase a higher yield with “safe money”, perhaps even just for a few months. Don’t do it!  It’s for emergencies or other important short-term goals. This is not the account to be used for maximizing long-term returns by risking short-term losses– that’s for the TSP, IRAs, and long-term taxable accounts.

A short-term account may earn a lower return, but its payoff comes when you need the money. It’s much easier to sleep at night if you know that you have the money available to cover an emergency. And although a CD may only pay a percent or two, in case of emergency the real savings come from the discounts given to those who can pay right away with a credit card, a check, or even an envelope of cash. You also want to be the buyer who can swoop in on a bargain, not the desperate seller who needs to raise cash. Your cash makes sellers and contractors very happy to give discounts, and that’s the ultimate payoff for short-term savings that are earning low interest rates.

If you simply must chase yield, then one way to make yourself feel better would be to accept the risk of an early-withdrawal penalty. Pentagon Federal Credit Union  has a $1000 minimum on their CDs, and terms up to four years carry only a six-month early-withdrawal penalty.  (This is where spouse & I park our stash of two years’ expenses to spend down during bear markets.)  Navy Federal Credit Union  does the same for up to five-year CDs.  An I bond in a Treasury Direct account will at least keep pace with inflation and carries only a three-month penalty for early withdrawal.

By the way, Brandi, that’s an excellent suggestion to use the emergency fund for the Savings Deposit Program.  Thanks!

Related articles:
Dollar Stretcher posts on “Money Rules to Break”
USAA: seven money rules to break
Where to put your savings while you’re in the military
Frugal living is not deprivation
Start saving early
Financial myths of retirement

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WHAT I DO: I help you reach financial independence. For free. I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers, veterans, and families. All of my writing revenue is donated to military-friendly charities.

  1. Now you have me really thinking! My husband and I currently have $15,000 in our emergency fund, but I can see us dropping this down to $10,000 in light of everything discussed here. First, $10,000 would still cover 3 or 4 months’ worth of our expenses. In addition, we only spend 50% of our income, so we have money coming in every month to respond to unexpected expenses. Also, as you pointed out, we would have months to respond to a potential separation. As for the Savings Deposit Program, you normally have at least a month or two of warning before a deployment, plus you can only deposit money once you have been in the combat zone for 30 days, so again, you have plenty of time to prepare. And we still have a credit card and taxable accounts available as a back-up. The clincher is looking at the financial cost of keeping the extra $5,000 in an emergency fund. We are only earning 1% on our savings account, and assuming we can earn 8% on our investments, having an extra $5,000 liquid costs us $350 per year, or $30 per month. In light of all of this, I think the extra amount of safety isn’t worth the price tag. Thanks for the great insight!!

    • You’re welcome! $30/month makes a difference… especially if you’re probably not going to use it for emergencies.

      I should point out that in retirement we no longer have an “emergency fund”– but we do keep two years’ expenses in cash for riding out recessions and bear markets. We’ve built that into a five-year CD ladder but could even go out to seven years if long-term interest rates (and early-redemption penalties) made it worthwhile.

  2. Good topic today. I have thought of this also. By having 60 days of leave saved I know I have two months of basepay that I could either sell back or take as terminal with all the benefits if my exit from the military was sudden. Can’t get to it if I need it but I can get time off if I need to go take care of an emergency and still have income coming in the door.

    My personal belief is 90 days of emergency fund is plenty becuase we pretty much can see anthing happening before it does or we have time to react. At the end of the day the military moves pretty slowly and you can stretch things out if you have too. If you are enlisted you know your ETS date so planning should be easy.


    • You’re right, I didn’t even think of the cash value of the leave balance. You’d either be cashing it in if you can’t get terminal leave, or using terminal leave (which includes special pays & allowances in addition to base pay) for the job search.

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