Household budgets are under strain. If surging energy bills weren’t already enough, there is also the rising cost of food, rent and other goods and services. And if you’re a homeowner there’s higher mortgage costs too.

So, what’s the best way to balance your potential emergency funding needs against your longer-term investment goals? How do you decide between the interests of your present self and those of your future self?

It’s a thorny question and one that will be personal to you and your household.

However, to help you think about these things, here’s a framework you may find useful.

Rainy day funding

First, remember that the goal of an emergency cash fund is to turn a potential crisis into a manageable setback. Pitch it right and it will give you the breathing room to get your life back on track. Therefore, it should take precedence over your investing, much like paying off your credit card debts.

But that’s not the only benefit because it can make you a more effective investor too.

Once you’re satisfied there is enough money in your ‘rainy day’ savings, it can give you the freedom to invest with more confidence to support your other goals. That includes taking on the right level of risk, so you are better able to grow your wealth in the long-term.

But how much should you have in emergency cash savings?

A sensible rule of thumb is to set aside enough money to cover at least three months of your outgoings. Given how the cost of living has been rising, this means you need more now than you used to.

It’s also worth thinking about what, potentially, you might one day need the emergency money for. While the specifics will be different for each person or household, we can broadly place financial shocks into one of two categories – spending shocks or income shocks – and planning for both is important.

Crisis? What crisis?

Spending shocks encompass a wide range of unexpected expenses: anything from a broken boiler to a last-minute flight to attend a family funeral.

Income shocks tend to be less varied. But the repercussions are often more serious, depending on your circumstances. Suddenly losing your job or an important contract is one example; long-term illness or having an accident is another.

Just over half of British households can cover a 75% fall in their household income for a period of three months from their existing savings, government data shows. So there is room for improvement, particularly among younger age groups, who have the lowest levels of emergency cash coverage¹.

There are also safety nets in place in the event of illness, especially if you’re employed rather than self-employed. In addition to the free healthcare available to all via the National Health Service, private health insurance may be available through your employer. If you’re too ill to work, you may also be eligible for sick pay over and above statutory sick pay².

Planning for spending and income emergencies may require a blend of strategies and will be shaped by your personal circumstances and choices. For example, some professions are more stable than others, just as some job skills are more in demand than others, so you may feel more or less confident about the income cover you may need. Similarly, if you only have third-party car insurance, you face a greater chance of a hefty repair bill in the event of a road accident.

Safety versus liquidity

While spending shocks are a frequent and inevitable feature of life, income shocks are rarer. When planning for emergencies, these differences need to be considered. Not all rainy days are the same.

You also need to consider your different assets – and which you can access first.

Most spending shocks are one-offs. They are sudden emergencies. As a result, you can prepare for them with a surplus balance of cash or by keeping some of your money in relatively liquid, low-risk holdings. This may be satisfied through a savings account, a money market fund that invests in short-term debt, or a combination of sources.

However, not all spending shocks are so transient. As we’ve discovered in recent weeks, for example, the potential for the mortgage market to suddenly change can have a lasting impact on the household budget if you’re on a fixed-rate deal and expect to come off it soon. High energy bills could also eat into our personal finances for longer. 

In this respect, it might be more apt to prepare as you would for a possible income shock, by drawing on some of your more liquid investments. While some investors who see themselves as especially vulnerable to income shocks may choose to set aside cash, for most investors it may be more useful to rely on some of the assets invested for your other long-term financial goals.

That could include some of the holdings in your individual savings account (ISA), for example. After all, many ISAs, including Vanguard’s, allow you to withdraw money and repay it within the same tax year without affecting your annual ISA allowance. 

Alternatively, you can consider income-protection insurance, although this may already be available through your employer. This can typically cover around 50% to 70% of your gross monthly income – both in the short-term and long-term, depending on the product chosen.

You could conceivably also dip into your pension savings to tide you over in an emergency if you’re 55 or older³. However, we would caution heavily against that because these funds are there to support you in retirement and you may need to rely on them for decades to come. There could also be tax implications⁴ and you may compromise your capacity to continue saving for your retirement⁵. So think long and hard before going down this route.

Thinking about the potential spending and income risks you’re most exposed will help you to decide just how big a rainy-day fund you need. It may even shape your investment strategy by helping you to determine the amount of investment risk you wish to take.

 

¹ ‘Financial resilience of households; the extent to which financial assets can cover an income shock’, April 2020, Office for National Statistics.

² Statutory sick pay is currently, £99.35 per week. It’s paid by your employer for up to 28 weeks.

³ Applies to most defined contribution pension pots. Age limit set to rise to 57 in 2028.

⁴ Although the first 25% is tax-free, income drawn from your pension forms part of your overall taxable income and is taxed at your marginal rate of tax.

⁵ By triggering the Money Purchase Annual Allowance.