It's a cardinal rule of financial planning: Clients should set aside cash for costly emergencies. But how much emergency cash is needed and when should it be used?
Many advisors recommend having enough money to cover three to six months of living expenses in an emergency. But what constitutes an emergency?
Typically, we think of financial emergencies as large-scale unforeseen events such as a health care crisis or structural problem in your home that insurance doesn't cover. A sudden five-figure bill can stymie the best-laid financial plan.
For advisors, the challenge is twofold. First, they need to convince clients to set up an emergency fund with sufficient cash to keep them afloat if disaster strikes.
Second, they must work with clients who want to tap their emergency cash reserves later on. Under what conditions should clients withdraw that money? And what if their definition of an emergency differs from what their advisor thinks?
The term "emergency fund" is in itself problematic for some advisors. Because they don't want to debate clients over what qualifies as an emergency, they may label it as "cash reserves" or "a peace-of-mind fund."
"We (advise) setting aside three to six months of income for a true emergency," said Tait Lane, a wealth manager at Merit Financial Advisors in Issaquah, Wash. "That sets the stage for what that money is used for: an unexpected expense that's an emergency, not a want."
He recalls a client couple in which the wife sought to withdraw about $30,000 for new carpeting in their home. The husband didn't deem that an emergency.
"She's a stay-at-home mom with young kids," Lane said. "In her mind, replacing the carpets was an emergency."
Weigh Pros And Cons Of Using Emergency Cash
Rather than take sides, Lane came up with a plan: The couple agreed to wait a few months before buying the carpet, allocating part of the husband's monthly compensation to save up for it.
During that time, the couple became aware of others in the husband's line of work facing layoffs. That motivated them to preserve their emergency fund for true emergencies.
Advisors know that it's dicey when they try to dictate to clients how they can and cannot spend their money. While some clients welcome such guidance, others resent it.
"The advisor needs to show the client the pros and cons of tapping emergency reserves as well as offer up alternatives to fund whatever emergency there may be," said Erik Baskin, an advisor at Baskin Financial Planning in Dayton, Ohio. "We can't tell a client no about spending their own money. We can only talk about the ramifications of such a decision and what some alternatives may be."
To clarify the fund's purpose, some advisors cite examples of the type of emergency that might trigger its use, such as a sudden job loss. Others take a different tack.
Baskin reminds clients of their stated values and goals. Then he asks whether their desire to tap their emergency cash aligns with their objectives.
"If a decision puts a goal in jeopardy or conflicts with their values, then the client needs to think long and hard about that or redefine their new values and/or goals," he said. "If their top three goals are to retire at age 60, fund their kid's education and take one big vacation per year, then we'll talk about how buying a nicer car (with their emergency cash) fits into that. Are their goals changing now?"
Pose Two Questions To Clients
While advisors may balk if a client wants to raid their set-aside cash for nonemergencies, the best response is to pose questions without subtly conveying disapproval. Probing to learn what's driving the client's urge to spend can uncover deeper needs and concerns.
Sara Stanich, a certified financial planner at Cultivating Wealth in New York City, likes to ask clients two questions: "What will the money be used for?" and "How will you replace it?"
"It can be awkward to ask those questions, but you've got to go for it," she said. "You want them to feel supported, not judged, and do what's in their best interest."
Identifying the client's motivation enables the advisor to put the current situation in a broader context. Peers or neighbors may be goading the client to overspend on luxury items. And what feels like an emergency today ("This is a once-in-a-lifetime investment opportunity!") may seem less urgent in a few months.
Stanich might encourage clients to rethink their spending priorities, especially if they're between jobs. Rather than focus narrowly on whether to tap emergency money for a specific expense, she will redirect a client's attention to their long-term plan.
"I'll say, 'We need to look at the big picture,' " she said.
