By Sarah Max
June 7, 2019
Having a rainy-day fund is key for weathering a job loss or paying for the proverbial roof that needs replacing, but the most profound impact is on retirement savings.
“If you don’t have liquidity, it can lead to a cascading line of bad decisions,” says Greg Klingler, director of wealth management for the Government Employees’ Benefit Association (GEBA). And those bad decisions can wreak havoc on retirement savings over time.
The Ripple Effect on Retirement
Taking an early withdrawal from retirement tops the list of bad decisions that can spring from not having enough savings. In a study released by E*Trade Financial last August, 60% of investors ages 18 to 34 said they had taken money from their retirement account; that figure is twice what it was in 2015.
The immediate effect of raiding retirement is a 10% early-withdrawal penalty, but that is small relative to what is lost over time.
Consider what happens when a 40-year-old pulls, say, $10,000 out of a $100,000 retirement account. At 65, it is the difference between having about $542,700 and $488,500, assuming a 7% return compounded annually, had that money been left alone. The alternative—taking on $10,000 in additional debt—can yield even uglier results over time.
Not having enough saved up can also wreak havoc on your view of risk. In a Wells Fargo survey conducted a couple of years ago, 59% of respondents said they focus more on avoiding loss than maximizing the growth of their investments for retirement.
While investors don’t want to be oblivious to risk, playing defense is no way to win the long game in retirement. Consider that hypothetical $100,000 balance for a 40-year-old investor: A 4% annual return compounds to $266,583 over 25 years, versus that $542,700 for a 7% return.
Yet another reason cash is king? “It’s peace of mind,” says Steve Lindsay, senior managing director of wealth management at First National Bank of Omaha. It might take time to salt away enough in savings to make a career change, for example, but it can be the difference between staying in a job you hate and making the leap to a career that can take you to the finish line of retirement, or beyond.
Getting Over the Savings Hump
Many people fall short on short-term savings because they set their sights too high. That might seem counterintuitive, but let’s face it: The rule of thumb of having three to six months cash savings can be daunting—so much so that many people give up before they begin.
“I always say that everyone who climbs Everest does it one step at a time,” says Klingler.
Just as you can build a healthy retirement nest egg by making regular contributions over time, you can get over the rainy-day savings hump by carving out a manageable amount to save automatically at regular intervals. For many people, it is easier to schedule smaller transfers to savings at weekly or biweekly intervals than it is to move a bigger chunk of change every month.
While there is no substitute for earmarking a fixed dollar amount for savings, so-called spare change apps can offer an additional nudge. Launched in 2015, the fintech Digit uses algorithms to analyze your checking account activity and transfer small amounts to an FDIC-insured account every few days or so. (This writer set aside more than $150 in a month without noticing seemingly random withdrawals ranging from $3.89 to $25.79.) Digit charges a $2.99 a month, but it might be worth it if it helps you get started on saving.
And here’s a hack that doesn’t cost a penny: Name your rainy-day fund something that resonates. It’s one thing to neglect your generic savings account, but you might think twice about yanking funds from an account called “Protect My Family.”
Find Your Savings Sweet Spot
Whether you go it alone or get help from technology, the most important step is just to get started. As your savings grow, however, you should set some goals.
Three to six months of expenses is the figure most planners use, but that amount can vary a lot based on circumstances. If you’re in a stable job and industry, you may be able to get away with less than three months, says Klingler, but if you work for yourself or on commission, you may need more than six months of expenses.
Also think about your rainy-day fund in the context of your other finances, says Klingler. If you’re retired and have a conservative portfolio of 50% stocks and 50% bonds, you may not need as much cash as you would if you have a stock-heavy portfolio. Likewise, you should also take into account other sources of liquidity, including home equity.
You, of course, never want to turn your house into an ATM, but having a home equity line of credit at the ready is a good stopgap while you’re building your cash reserves. “As long as you don’t draw on the funds, it costs you nothing,” Klingler explains.
In the meantime, you can sleep easier at night—knowing that you’re covered in the case of a small leak or major deluge.
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