Welcome to Day Two of the 30 Day Financial Transition Challenge. Today’s article focuses on the concept of sufficient liquidity, which is the second of the Five Fundamentals of Fiscal Fitness.
Bottom Line Up Front (BLUF)
Having sufficient liquidity means that you’re able to handle life’s emergencies. Having enough money set aside for emergencies will help establish the foundation upon which you can build your other financial goals.
Whether it’s a temporary emergency or a long-term concern, it’s important to have enough money set aside to address the unexpected. If you don’t have enough money set aside to handle unexpected issues, then you’ll end up having to find money elsewhere other places, such as retirement accounts, college savings accounts. Even worse, you may end up taking on debt, which is counterproductive to your long-term financial goals.
Your goal should be have enough money to address both ordinary and extraordinary emergencies. This article will give you a quick breakdown on how you define both types of emergencies, and help you formulate a plan of action to get there.
For more detail, feel free to check out the following articles that I’ve previously written:
- How Much Money Should I Have in My Emergency Fund?
- Five Fundamentals of Fiscal Fitness #2: Maintain Enough Liquidity
- 5 Military Considerations About a Debt Management Plan
What you need
For this exercise, you need to know what your total income is. This should be the same number that you used in the Day 1 exercise, Paying Yourself First. Additionally, you’ll need access to all of the accounts where you keep cash & cash equivalents.
Also, let’s review the definitions of ordinary and extraordinary emergencies.
Ordinary emergency: These are emergent issues that require immediate cash. Or they require cash within the next week. Things like car repairs, a roof repair deductible or an emergency room bill count as sudden emergencies. They won’t have a permanent impact on your finances, and you’ll eventually be able to replenish your emergency cash. Use the following guidelines to figure out how much you need for ordinary emergencies:
- Stable job and regular income: set aside 10% of your annual income.
- Your own business or if your monthly income is variable (for example, based upon commissions or seasonal income): set aside 20% of your annual income.
- Retired from all jobs (not just the military): set aside 30% of your annual expenses (not income).
- Retiring from the military, and expect to be unemployed, then you should set aside 40% of your annual expenses to offset whatever isn’t covered by your pension.
Extraordinary emergency: These are things that will permanently change your life, and have a direct financial impact on you. Things like a forced early retirement, permanent illness, or significant injury. You might not need cash this week, but you do need to buy yourself time and space to make major life adjustments. For this, you will want to set aside twice as much as you have for an ordinary emergency.
A couple of points about extraordinary emergency funds:
- Having extraordinary emergency funds will help you avoid the ‘triple whammy.’ A triple whammy is any situation in which three significant financial events happen within a very short period of time. For example, losing your job, placing a loved one in a nursing home, and the stock market going down 10% could be considered a triple whammy. This is the worst possible time to liquidate investments, and is exactly the reason why you want these funds in cash. Even more importantly, you’re in the middle of a major career change. You already have one or two hits against you, and need to protect yourself accordingly.
- Anything that is cash or cash-equivalent counts, regardless of where it is. This includes the cash portion of your retirement accounts. Why? Because you’re only going to touch this money in the event of something so drastic that the normal rules apply. For example, if you’re hit with a cancer diagnosis, you’re going to rethink your entire life, including your finances. You need all available resources to buy yourself time to reorganize your new life. This will be your primary concern, not tax implications.
- Anything in securities, no matter how ‘conservative,’ DOES NOT count. These things do not count because if you get hit, you do not want to be subject to stock market fluctuation. You want the ability to get this cash without having to take a hit by selling investments at a bad time.
- Home equity DOES NOT count. This is liquidity we’re talking about. Home equity, while convenient, is another form of debt. While it’s great to have access to credit, you do not want to rely upon credit to get you through a crisis, particularly an open-ended one.
1. Figure out what numbers you need to have. This is pretty straightforward. Figure out what situation you’re in (stable job, transitioning, retired, etc.) and calculate what you need to set aside for ordinary and extraordinary emergencies. This is your goal.
2. Ordinary Emergencies.
- Figure out how much money you have in cash. This includes savings, checking, money market accounts, etc. If you can access that money within 1-2 business days, it counts. If you can’t access the money that quickly, then it does not count as cash.
- Figure out the difference. Simply subtract how much you have from how much you need. This is your savings goal.
3. Extraordinary Emergencies.
- Figure out how much money you have in cash and cash equivalents. This time, we’re going to include any cash, or cash equivalents. For example, a 6 month CD is not cash. However, in 6 months or less, that CD will mature. For this, let’s include:
- CDs and bonds with maturities less than 6 months
- Cash amounts in all accounts, including your retirement accounts
- Figure out the difference. Simply subtract how much you have from how much you need. This is your extraordinary emergency savings goal.
4. At this point, you should have two numbers. If you’ve met your goal, great! If not, we’ve identified where you need to be. That’s all we should expect to achieve today. We still have a lot of information to collect before we make any decisions. As we go through the 30 day process, we’ll start putting some of these pieces together so that you can formulate a plan that addresses all of your financial concerns, and prioritizes your action plan.
To wrap up, today you’re going to figure out where you stand with regards to your liquidity. Figure out where you stand. That’s it.
In Day 3, we’ll discuss the importance of paying off personal debt.