How to Determine the Appropriate Size of an Emergency Fund

This article covers how to determine an appropriately sized emergency fund to address any sudden loss of income.

For those still working and not yet financially independent, it often makes sense to coordinate the size of your emergency fund with the elimination period of your long-term disability insurance policy.  Depending on the long-term disability insurance policy, it may take another 30 days or so before the benefits accrue and the first monthly disability payment is made after meeting your elimination period.

For example, if your long-term disability insurance policy has a three-month elimination period and does not make the first payment until you have a month of accrued benefits, you may want your emergency fund to cover at least four months of your essential expenses.  This way, if you were to become permanently disabled today, your emergency fund could cover those essential expenses until your long-term disability insurance policy began making payments, four months after you became disabled, in this example.

Similarly, if your income were to abruptly stop due to a job loss, having an emergency fund may allow you a few months to find another job before spending through your emergency fund and having to start selling other assets to cover your essential expenses.

Checking accounts, savings accounts, and money market accounts are commonly used for emergency funds.

Having too small an emergency fund, given a sudden loss of income, means you may have to sell other assets at inopportune times, such as selling equities from a brokerage account when the market is significantly down.

On the other hand, having an excessively large emergency fund can be problematic because those excess dollars in the emergency fund usually do not keep pace with inflation, which leads to a loss of purchasing power, especially over long time horizons.  For example, if you have a $300,000 emergency fund and essential expenses of $7,000 per month, this equates to an emergency fund of 43 months of essential expenses ($300,000/$7,000 of essential expenses per month = 42.86 months of essential expenses).

In this case, a more appropriately sized emergency fund may be around six months, or a $42,000 emergency fund [(6 months)($7,000/month) = $42,000], with the other $258,000 ($300,000 - $42,000 = $258,000) transferred into other accounts which are expected to keep pace with or outpace inflation.

If you have a short-term disability insurance policy provided through work, this may also influence the size of your emergency fund.  If your short-term disability insurance policy covers all of your essential expenses, you may not need any emergency fund to cover the risk of a short-term disability.  Of course, other causes of sudden loss of income, such as a job loss, would not be covered by a short-term disability insurance policy, so having an emergency fund of some amount would probably still make sense.

Purchasing a short-term disability insurance policy may or may not be cost-effective depending on the facts and circumstances.  It may be more cost-effective to self-insure against a short-term loss of income, which is not a catastrophic risk, by establishing an emergency fund rather than purchasing a short-term disability insurance policy.

If you are retired, the appropriate size of your emergency fund is influenced by how much guaranteed income you have per month. For example, if you have $7,000 of monthly essential expenses and $5,000 per month of guaranteed income from Social Security Benefits, annuities, and pensions, your essential expense shortfall is only $2,000 per month, so a six-month emergency fund would be $12,000.

If you are a prospective client and would like to learn more about hiring us for a financial consultation, where, among other things, we would help you establish an appropriately sized emergency fund, please visit our Schedule Meeting page.



Mike McErlane, DO, MBA, CFP^®, CFA^®, RICP^®, EA, MCEP^®

Mike McErlane is the owner and founder of Comprehensive Financial Planning for Doctors, LLC based in Frisco, Texas.

Comprehensive Financial Planning for Doctors, LLC (CFPFD) is an Investment Adviser registered with the Texas State Securities Board.  Registration of an Investment Adviser does not imply any specific level of skill or training.  CFPFD only transacts business in states or jurisdictions in which it is registered or exempt from registration.  A copy of CFPFD's current disclosure brochure is available through the Securities and Exchange Commission's Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov.

The opinions and analyses described are subject to change at any time without notice.  Any information is considered general and is not intended to provide any specific advice or recommendations.  Your use of the information is at your sole risk.  You should consult with your financial advisor, attorney, tax advisor, insurance agent, or other professional advisor before taking action on any information or implementing any strategy.