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The amount of emergency reserves you should have is an age-old question and the answer has remained a cookie cutter one. Three to six months of living expenses has been the standard answer for as long as I can remember. However that approach leaves most severely under-prepared because no longer is tenure in a job synonymous with assured job security. The necessary planning needed to protect against unplanned economic and market turmoil and corporate downsizing has needed to change to better protect against these risks.
Emergency reserves are used to provide a buffer in case of emergencies such as car repairs, fixing a water heater or air conditioning unit, etc. so that you do not need to go into debt for these types of occurrences. These reserves also provide for living expenses if you should be out of work without pay for an extended period, because of a short term disability or an unexpected layoff.
I have noticed an emerging trend in corporate downsizing, the targeting of employees over the age of 50 in what has historically been peak earning years. If you are parents with college-aged children you are probably still paying for college and looking to your top earning years to get retirement savings back on track. Involuntary job changes during peak earning years can unravel retirement plans very quickly, as the time to find another job increases with age. There is also the real risk that your new paycheck will be only a fraction of what you had before.
The rule of three uses an age-banded approach of three times monthly net earnings instead of the standard cookie cutter 3-6 months approach. It provides better protection by taking into account the increasing job/career risks faced during each decade of a career. Someone in their 20s should have 3 months of net earnings for each decade, for example, 2 decades x 3 months of net earnings for a total need of 6 months of reserves. If you are in your 30s you should have 9 months of net earnings, 3x3, for reserves; if you are in your 40s you should have 12 months, 4x3; and in your 50s you should have at least 15 months of reserves.
This approach better insulates against the increased potential unemployment and job search risk associated with growing older and advancing through your working career. As you advance through each age band, you only have to increase your savings by an additional 3 months over each decade, which makes for an easy savings goal too.
A common-sense, long-term financial approach monitors and adapts as needed to changing times. Don’t get caught short in today’s realities following yesterday’s outdated financial rules.