emergency account

Preparing for a Recession

Philip Brewer — Fri, 28 Dec 2007 17:14:06 +0000

I don't know if a recession is coming. Nobody does. We may dodge the bullet for a while. On the other hand, the economy may already be in recession. You don't need to know the future, though, to make some wise moves.

Recessions hit everybody differently, so we'll take a look at how things tend to play out for people in different situations. First, though, it helps to understand what a recession is. (See also: The Recession Glossary)

What Happens in a Recession

A recession is a reduction in the total amount of business done in the economy.

When conditions are right for a recession almost anything can set one off — anything that prompts businesses to decide to produce less, or prompts consumers to decide to buy less. High oil prices, for example, may lead consumers to cut back on food and clothing purchases so they can afford enough gasoline to get to their job. A credit squeeze may force businesses to scale back, because they can't borrow enough to buy all the raw materials they need to keep their factories running at full capacity.

Once a recession gets started, it tends to spread. Every business that sells less also buys less — meaning their suppliers are doing less business. Pretty soon, all those businesses are laying off employees — meaning a bunch of would-be consumers no longer have any income, so they're buying less as well.

How It Affects You

A slowdown in business hits you directly if you own a business. It hits you one step removed if you work for a business (or want to) — jobs will be harder to find, raises will be smaller, layoffs will be more common.

A lot of people don't work for a business. Some work for governments (federal, state, local). Others work for institutions, large and small: colleges, universities, hospitals, orchestras, art centers, food pantries, land trusts (any of which may be purely independent or government-sponsored to some extent). People who work for governments or institutions are a second step removed from the impact of a recession, but that doesn't make them immune. The decline in business activity always reduces tax receipts to governments, leading to cutbacks especially at the state and local level. A general decline in prosperity often reduces charitable donations, leading to cutbacks at private institutions. Again: fewer jobs, less secure jobs, smaller raises.

There are also, of course, people who don't work in the money economy. Putting aside children and non-working spouses (who face the same circumstance as their family breadwinner), I divide these people into two groups — the ones who are actually out of the money economy (subsistence farmers, freegans, prisoners), and the ones who are are in the money economy but their income doesn't depend on the work they do (the wealthy, retirees, people on welfare).

It's an important distinction, because people in the second category are depending on promises — the income from investments, pensions, social security, welfare, and the like — which are at best only as sound as the finances of whoever is paying the money. In a recession, that soundness is threatened.

If you live on promises, remember that promises get broken — especially in a recession.

What to Do

So, what can you do to soften the blow if a recession hits?

Reduce Your Expenses

The first key, whether your income is tied to a business or not, is to reduce fixed expenses. High variable expenses can be tolerated, as long as there's an income stream to pay them. But high fixed expenses will wreck your finances very quickly if the income stream dries up. This means reducing debt and avoid new obligations (fitness center memberships, burglar alarm contracts, etc.). For businesses, it means postponing hiring (hire temps instead) and postponing raises (instead, offer bonuses conditioned on profits).

Increase Your Emergency Fund

The second key is to boost your emergency fund. A temporary income shortfall doesn't need to become a financial catastrophe, as long as you have enough cash on hand to tide yourself over. Resist the temptation to rely on credit as your emergency fund. It can be tempting to figure that paying down revolving debt frees up part of your credit line for use in a future emergency, but that's not the same as an emergency fund. At any time, but especially during a recession, lenders can cut credit limits, refuse to extend further credit, or simply get out of the business entirely. Have an emergency fund that doesn't depend on someone making you a loan. (After all, the classic reason to tap an emergency fund is when you've just lost your job — which is exactly the time that a creditor would be especially likely to cut off your credit.)

Diversify Your Income

The third key is to diversify your income sources. If your goal were maximum total income, diversity would probably be the wrong choice. There's almost certainly one income stream that would give you the highest total income if you put all your effort there. The problem is, that's not a stable strategy. A better choice, especially if a recession is in the offing, is to try to arrange several income streams, some of which don't depend too much on a thriving economy.

Reduce Your Dependence on Money

The fourth key is to reduce your dependence on money economy. This is the one sure way to protect your family from recession — provide for their needs without having to spend money. It seems unnatural in today's world for people to grow their own food and make their own clothes, but, to the extent that you can do so, you're in a position to just ignore the ups and downs in the economy. All the other options are just stop-gaps — they help you keep things together until the economy picks up again. This one actually solves the problem.

Same Strategies, Different Balance

Wise Bread readers will recognize these four strategies as the same core principles that we talk about all the time, so I'm not telling you to do something new. Rather, I'm suggesting that you alter the balance. The downside of all these strategies is that in good economic times they result in a lower standard of living than you could achieve if you followed more mainstream personal finance strategies. In bad economic times, though, these are the winning strategies.

In good economic times, a business that refuses to use debt to grow will inevitably fall behind its more aggressive competitors. In bad economic times, the business that avoids debt will survive while the others will fail. For individuals, the calculation leans even more away from debt.

On top of that, a recession provides many opportunities for someone with ready cash. When no one else is buying, someone with cash in hand can get some terrific bargains — enough to catch up with years' worth of "lost opportunities" for growth.

We don't know for sure that bad economic times are coming, but the threats to the economy (housing collapse, credit crunch, spiking prices for oil and food) are as great as they've been in a long time, and the potential missed opportunities from an excess of caution are smaller than during a boom.

Now is the time to go with these strategies — accepting the slower growth and lower standards of living that go along with them as a small price to pay for security and a reasonable shot at some big opportunities ahead.

Remember, a recession is a time when promises get broken. Business fail, leaving both their debts and their employees unpaid. Tenants don't pay their rent. People who have always paid their bills on time suddenly can't. Sales fall through. Wherever your income comes from, it is at some risk. Arrange things so that you can face that risk.

Update: The National Bureau of Economic Research, the group that makes the "official" call on the beginnings and ends of recessions, announced on December 1st, 2008 that a recession began in the US in December 2007, the month this post was written.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Figuring the Size of Your Emergency Fund

Philip Brewer — Wed, 10 Oct 2007 01:33:14 +0000

The usual rule of thumb is 3 to 6 months' income. Of course that's silly--the size of your emergency fund needs to be based on your spending, not your income. But even 3 to 6 months' spending is an arbitrary figure. Here's a few tips on sizing your emergency fund.

Do you need an emergency fund?

I certainly think you do, but there are those who have different ideas.

There are some who would have you invest all your savings directly into equities. Under their plan, if you have an emergency, you just charge it on credit and then pay off the debt out of income. If necessary, you can sell equities to pay it off--but you can sell the equities at a time of your choosing. That's not an insane plan, but I'd only consider it if you have: a good job in a growing field, experience and credentials that would let you quickly find another, your expenses are low compared to your income, you have some assets, and you have access to credit.

Otherwise, you definitely need an emergency fund.

Purpose

The basic purpose of an emergency fund is to tide you over if you lose your job. Because money is fungible, the same emergency fund can cover other financial gaps--unexpected expenses, or the unexpected loss of non-job income. It's there to give you some time to make the necessary adjustments when a gap develops between income and expenses--either get your income back up or cut your expenses down to match whatever income you can manage.

Basic factor

The basic factor in the calculation is one month's minimum expenses.

If you have a budget, go through and strike out any expenses that you're confident could be postponed for a few months, if necessary (entertainment, dining out, vacation travel, new glasses, new clothes, etc.).

If you don't have a budget, make a list of:

Minimum monthly bills This is basically all your bills that are either necessary to live, or that you are contractually obligated to pay: rent or mortgage, utilities, car payment, other debt payments, etc. Depending on contract terms, you may have monthly bills that could be canceled on a month's notice or less--cable TV, fitness club membership, and so on. If you would cancel these in the event of a short-term financial crises, you can leave them off the list. Otherwise, include them.
Routine monthly expense This includes groceries, gas for the car, cost of prescriptions beyond what insurance covers, etc. You can take a minimalist approach here--assume you'll be eating lots of rice and beans--but be realistic.
Job-hunting expenses Be sure to include all the expenses that you'd need to support a job search--your phone bill, internet access, enough money for gas (or bus tokens) to get to job interviews, dry cleaning for interview clothing, etc.
Other mandatory expenses This would be tuition, taxes, insurance payments (monthly share for annual expenses), etc.

Add that up. That should give you your rock-bottom expenses for one month.

How many months?

Why is the rule of thumb three to six months? It has to do with how long it takes to find a job--and how long it would take to make the necessary adjustments if you couldn't find another job. Three months is barely enough, because it's not unusual for it to take a month or two to find a new job, even if the job market is strong. Only after around three months of looking and not finding a new job would you necessarily grasp that you're facing serious difficulty and realize that you needed to take some drastic steps to reduce your expenses. It would sure to nice then to have another three months in your emergency fund, so you have some time to make those adjustments.

As for having an even larger emergency fund, there's a trade-off with being able to invest for a higher return. Bringing the total up to, let's say, twelve months, diverts an awful lot of money away from the stock market and other long-term investments, simply as a precaution against (hopefully) unlikely catastrophes.

I'd say, start with a default value of six months, and then consider making some adjustments.

You can adjust the number of months down if you have:

Other income If your spouse works--and wouldn't likely become unemployed at the same time as you--then you might be able to get by with three months' expenses. Similarly, if you have investment income, a side job, an allowance, a trust fund, alimony or child support--anything that brings in cash independent of your job--you can make a similar adjustment.
Substantial liquid assets If you've got a tidy sum in a mutual fund or a brokerage account, then you may not need as much of an emergency fund. It has to be money that wouldn't be expensive to use--money in a 401(k), IRA, or similar tax-sheltered plan doesn't count. Assets that can't readily be turned into cash, such as real estate or a car, don't count either.

(Note: You might, instead of adjusting the number of months, reduce the size of your rock-bottom expenses by the amount you expect to make in non-job-related income. I recommend against that for two reasons. First, it makes the whole calculation dependent on an accurate estimate of your non-job income. Second, it makes the calculation brittle, in the sense that changes to your non-job income ripple through to the final number. Instead, figure the minimum monthly expenses without regard to non-job income, then just adjust the number of months. The exception would be if your non-job income is both large compared to your minimum monthly expenses and quite reliable. In that case it probably would be best to just subtract it out of your minimum monthly expenses.)

You should adjust the number of months up if you have any reason to worry that you might have trouble finding another job--if you lack credentials, for example, or your current employer is the only game in town, or you're working in a declining field.

Where to keep your emergency fund

I suggest you keep at least part of your emergency fund in your local bank. There are times when even one or two extra days to move the money could cost you a lot. With that proviso, you can consider any of the usual suspects: savings account, money market account, internet savings account, money market mutual fund. A while back I talked about stashing part of your emergency fund in treasury bills, which gives you maximum security, a good rate of return, and scheduled access to your money.

Worth having

There are only two reasons not to have an emergency fund:

You're broke or in debt If you've got installment debt, the interest rate you could get on your emergency fund will almost certainly be far less than what you're paying on your debt. Even in that case, you probably want to have an emergency fund greater than zero, if only to carry you over the minor glitches like a holiday weekend delaying access to your paycheck. An emergency fund of one month's minimum expenses might be a reasonable target.
You're investing for a better return If you're getting great returns in your stock portfolio, it can seem stupid to have several thousand dollars sitting around earning 4.5%. It's a matter of trade-offs--the hypothetical lost return on a few thousand dollars on the one hand, versus the value of an emergency fund that's there when you need it on the other. Up to six months' minimum expenses, I think the advantages of an emergency fund outweigh the potential lost investment return.

An emergency fund is worth having, even if your job is very secure. There are all sorts of other minor emergencies that can cause a problem for someone who doesn't have a ready source of emergency cash--a miscalculation in a check register leaving insufficient funds, a payroll error by your employer leading to an underpayment, a call from a relative trying to scrape together bail money.

An emergency fund can also be used to take advantage of opportunities, both big (a business deal you've been trying to close for weeks is suddenly available--but only if you show up with a cashier's check by 5:00 PM) and small (a chance to stock up on tomato paste at 50% off). Don't put yourself in a position where a large fraction your emergency fund is tied up in "opportunities," but don't hesitate to use it either.

You ought to have an emergency fund equal to your minimum monthly expenses times at least three months, and preferably six months, and keep it to be stashed where you can get at least a large fraction of within one business day. It's one of the basic rules of personal finance for good reasons.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: