Tuesday, 23 October 2007

Why an Emergency Fund? Part 1: Death

It seems to be a common truism or rule of thumb that everyone should have at least three to six months of living expenses in the form of cash. A quick Google search uncovers such advice at About.com, Bankrate.com, bloggers such as ChristianPF.com, TheSimpleDollar.com, the StingyInvestor, mainstream financial journalists like Jonathan Chevreau and professional financial planning guides like the CF1 Manual (unfortunately not available on-line) of the Chartered Insurance Institute's Certificate in Financial Planning in the UK. There is at least one dissenting voice at the Financial Blogger who states that one need only put in place a line of credit. But even he doesn't dispute the basic premise that there is such a thing as a financial emergency, an unexpected event that can provoke dire consequences without a fund.

Being the sceptic that I am, I will take a closer look at how unexpected and how dire such ''emergency events'' really are. Risk analysis and risk handling are a well established discipline in industry for project management (I knew that PM certification would serve me well some day...) so why not apply it to personal financial management? That involves identifying risk events, assessing their probability, the magnitude of the negative consequences, the alternative methods of dealing with the risk (which includes everything from preventing or actively reducing the chances of the risk occurring, transferring the risk to someone else at a price or simply doing nothing and accepting the chance).

Event #1 - Death
Probability - Nowadays, the life expectancy at birth is roundabout 80 years for men and women in Canada. That means it is unusual for people to die prematurely, much as we grieve for those unfortunate few. The younger you are, the less chance of dying soon. Insurance companies know this and charge less for life insurance for young people. In his fine book Insurance Logic (which I have reviewed here), Moshe Milevsky presents some data from Stats Canada that shows how rare is premature death. Though the data is from 1996, there probably has not been a big shift to today; if anything, I'd guess early death is a little less likely. Below is the table reproduced. It certainly surprised me.

What is the Probability of Dying Within the Next 10 Years?
Current Age Female Male
30 0.5% 0.9%
40 1.0% 3.0%
50 3.0% 6.0%
60 9.0% 16.0%
70 22.0% 35.0%
80 50.0% 66.0%

Cost - The first direct effect is the cost of the funeral and burial. Estimates range from $4,000 to $15,000 (e.g. Sandra E. Foster in her book, You Can't Take It With You, p.283). It seems the most common number is $5,500 to $7,500. This is a number which obviously can be controlled to a significant degree depending on the options one chooses.

The second effect is the possibility that the person dying may have dependents, for whom the disappearance of the breadwinner may have disastrous consequences.

Risk response -
  1. First, note that by the age when death becomes a much more likely event, people will have reached retirement age and probably have accumulated savings or investments of other kinds to pay for funerals. Financial institutions will almost always allow the executor or family members to access such reserves of a deceased person for funeral expenses so it doesn't have to fall on you to pay for someone else before an estate gets freed up by probate. Investments can be sold within a few days and the money made available long before the bills come due.
  2. Second, as noted above, death expenses can be kept at the lower end and that can decided at the time of the event.
  3. Third, a person can avoid the problem by pre-paying for funeral expenses to a funeral home. The amount put aside can even grow tax-free waiting for your demise, a last comforting thought for those scrooges among us. Since for all but one person in history (and even that is disputed by some), death is a certainty, if you have the capability of putting money aside for an emergency fund then you can also direct that money to pre-paying your funeral.
  4. Fourth, you can buy life insurance or just funeral expense insurance. This can spread the cost out in small monthly payments. Maybe you will even die early and get a bargain.
The response to the support for dependents should be dealt with through insurance, not an emergency fund. Death isn't temporary so a short-term fund of six months of living expenses won't do the job.

In short, death isn't a good reason to have a highly liquid emergency fund.

But there are other possible reasons that I will examine in the next posts: job loss, home repairs, injury or illness, car repairs, divorce/separation, legal problems, care for parents/relatives, pregnancy, wedding. And once all these have been reviewed we'll see where that leaves us overall.

1 comment:

The Financial Blogger said...

I am glad to be a dissenting voice because the emergency fund is definitely not necessary.

In the event of death, I think that I good financial plans must include your insurance coverage. If you don't have a life insurance policy, you are not making a full financial plan. Therefore, if you ever pass away, your life insurance should kick in and cover the cost (it should do much more than that but the very basic would be the cost of the funeral).

I'm looking forward to read why ones should park money aside forever and wasting good return on it a.k.a having an emergency funds ;-)

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