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Funding a Safety Net: Calculate Your Target Amount

Don’t know how much to set aside for emergencies? Don’t let uncertainty stop you from saving. We’ll help you figure out how much you should save so that you can feel prepared.

Articles by Nick Holeman, CFP®

By Nick Holeman, CFP®
Financial Planning Expert, Betterment  |  Published: June 25, 2019

An emergency fund should contain enough money to cover your basic expenses for a minimum of several months.

How much do you actually need to set aside for emergencies? No one can predict the exact timing or cost of future emergencies any of us will face. However, we’ll provide recommendations to help you be as prepared as possible, based on what we know about you.

How much do you need?

Calculating how much you’ll likely need in your Safety Net might seem difficult. Luckily, we can help. We’ll recommend a target savings amount for you when you set up your Safety Net goal in your account, based on the formula below. You can also use this formula on your own to determine a target amount for your emergency funds.

1. Estimate your monthly expenses.

Your expenses are the starting point of our calculation. Unfortunately, many individuals are unaware of their average monthly spending. That’s why we use research from the American Economic Association and the National Bureau of Economic Research to estimate your average monthly spending based on your gross income.

The data shows that, on average, lower income households tend to spend a higher percentage of their income. As your income increases, both your taxes and savings will generally increase. Even though you will now likely spend a higher dollar amount, that amount represents a smaller percentage of your overall income. The graph below shows how the percentage of your spending generally decreases as your income increases.

Graph showing spending decrease as income increases

Data: Betterment analysis of self-reported income and estimated tax rates; American Economic Association; National Bureau of Economic Research. The chart shows assumed rates of spending, savings, and effective taxes for a single individual with no additional information about location, actual savings, or Social Security benefits. The default location is Colorado, which is roughly equivalent to the U.S. national average for cost of living and state taxes.

Knowing this information, we can easily estimate your monthly expenses as a percentage of your income. For example, if your gross income is $100,000, we can estimate that your expenses will be about $55,000 per year, or in other words, $4,600 per month.

2. Decide how many months you want to cover.

Once we estimate how much money you spend per month, the next question is—how many months of expenses should your emergency fund be able to cover?

One of the reasons to build a Safety Net is to prepare for the chance that you may unexpectedly lose your job. We looked at data from the United States Bureau of Labor Statistics, which shows that the median duration of unemployment is about three months. This is why we recommend that you save enough to cover expenses for at least three months.

Continuing our above example, $4,600 of monthly expenses x three months = $13,800.

Of course, there are other potential uses for your Safety Net aside from just losing your job—such as medical bills, auto repairs, etc.—but this provides us with a reasonable baseline number.

3. Last but not least—add a buffer.

The third and final step in our Safety Net formula is adding a buffer for downside protection.

Rather than holding on to cash, we believe you should invest your Safety Net in a low-risk, globally-diversified portfolio of 15% stocks and 85% bonds. The reason behind this is that holding too much cash usually means your money isn’t working as hard for you as it could be. And because the national average interest rate for savings accounts is only 0.09%, holding too much cash could mean you’re actually losing money because of inflation, which generally can be around 2% per year.

Investing always comes with risk, and that means your Safety Net could fluctuate up and down in value. To account for this known fact, we recommend that you add a buffer to the target amount you’re trying to reach in your Safety Net.

Our recommend buffer amount is 15% above your original target amount. Our 15% stock portfolio’s worst performance in a historical backtest would have been -11.4%, between the timeframe of May 2008 and November 2008 (source: Betterment data).**

Continuing the same example from above, if three months of expenses = $13,800, then you would take $13,800 x 115%, which would give you a final target amount of $15,870 for your Safety Net.

Reasons to Adjust Your Safety Net Target Amount

For many customers, the above formula is more than detailed enough to meet their needs. However, we allow you to adjust your Safety Net target amount, if you choose to do so. Below are a few reasons for why you may consider adjusting our default Safety Net target amount recommendation.

You don’t want to invest your Safety Net.

Some investors may not be comfortable with our advice to invest emergency funds. Instead, you may prefer to keep your Safety Net in cash, or a savings account alternative.

Choosing to keep your Safety Net in cash may reduce the need for the 15% buffer amount we discussed earlier, but remember that it might also mean lower expected returns over the long run.

Whether you choose to invest your emergency funds or keep them in cash is up to you. The most important thing is that you are working towards having any type of emergency savings at all.

Your income isn’t stable.

Our default calculation uses three months of expenses because that’s the average length of unemployment in the U.S. However, sometimes you may need to dip into your emergency fund, even if you haven’t lost your job.

If your income varies and isn’t the same from month to month, it’s possible that even though you’re still employed, you need to use your emergency savings due to a rough month or two. This may be the case for those who work in sales or another commission-based type of job. An unsteady income stream may cause you to tap into your Safety Net more often than someone who is a salaried employee with paychecks that occur regularly.

This can be particularly tough if a few bad months occur close together, before you have time to refill your Safety Net. This is why, if your income is unstable, you may want to increase your Safety Net to cover 5 or 6 months worth of expenses.

You are the sole/primary income earner.

If you are the sole breadwinner in your family, losing your job could be catastrophic to your family’s finances. The loss of your job could mean that your family has no income at all.

Compare this scenario to that of a family where both spouses work and earn similar salaries. If one of them loses their job, it would be tough, but at least they have another source of income to help weather the storm until the unemployed spouse finds another job.

If your family only has one income earner, you should consider having a slightly larger Safety Net.

Your expenses may not be adjustable.

If you had a large medical bill or necessary car repair, would you be able to cut back on your expenses temporarily? If a large portion of your monthly spending is discretionary, this might be fairly easy for you to do. Maybe you won’t go out to eat for the next couple of weekends, or you delay that vacation you were planning. It wouldn’t be fun, but you could get by.

If this sounds like the case, maybe instead of saving for three months of total monthly expenses, you could consider saving up only enough for three months of your fixed and unavoidable expenses, such as utilities and rent.

However, if the majority of your monthly expenses are fixed, you won’t have this option. You can’t temporarily cut back on student loan payments, rent, or utilities. If these unavoidable expenses make up most of your spending, you may need a larger Safety Net.

Your personal risk tolerance varies.

Lastly, don’t forget your personal risk tolerance. Some customers are comfortable with 1-2 months of expenses in their Safety Net, and others can’t sleep without having a full 12 months worth of expenses tucked away. To each their own.

While we caution against going too small with your Safety Net, ultimately the decision is yours and comes down to how you prioritize your financial goals.

Let’s get prepared.

Having emergency savings is a critical component for your financial health. We help make it easy by estimating how much you should have in your Safety Net, so you don’t have to. Since there are reasons why you may need more or less emergency savings, you can adjust your target to better match your individual needs.

One last piece of advice: Make sure you only use your Safety Net for true emergencies. Try not to dip into it unless absolutely necessary.

Click here to start saving towards your Safety Net today, or speak with a Betterment advisor who can help you set up your Safety Net as well as other financial goals.


** Please see https://www.betterment.com/resources/betterment-historical-performance/ and https://www.betterment.com/returns-calculation/ for more details on how we calculate historical performance. Please note that this figure is based on back-tested data. Backtesting is the process of evaluating a strategy, theory, or model by applying it to historical data and calculating how it would have performed had it actually been used in a prior time period. They do not represent the results of actual trading but were achieved by means of the retroactive application of a model designed with the benefit of hindsight. Backtested performance is hypothetical and does not represent actual performance and should not be interpreted as an indication of such performance. All back-tested performance has a chance for loss and/or profit. Furthermore, clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the backtests. This back-test is based on actual data, and includes the application of Betterments 25 basis points management fee and fund level fees. This assumes reinvestment of dividends, and daily portfolio rebalancing.

Contributing Authors

Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment

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