Tuesday, 30 October 2007

Why an Emergency Fund? Part 2: Job Loss

This is the second in a series looking at the need for a special emergency fund to tide one over through various crises. Part 1 looked at Death.

Today's installment examines involuntary job loss, aka layoff, firing, redundancy, downsizing - take your pick, they all can hurt just as much financially and perhaps emotionally as well. Maybe some forms of suddenly voluntary quitting a job, like abuse or harassment, can be included too, the principles and effects are the same.

In keeping with the pattern of the series, I'll first look at the probability of the event, then the potential cost/consequences and finally the alternative risk responses to decide whether an emergency fund is needed at all and if so, how much is needed for this component. At the end of the series, I'll add the results up and deal with what form the fund (if any) should take.

Event #2 - Job Loss
Probability - There is no single answer for everyone, it depends on your circumstances and you must figure the chances for yourself.

If you are retired, then it's pretty hard to get laid off, no? Cross yourself off as needing an emergency fund because of job loss. Even the 17% or so of retired people who do work mainly seem to do so because they enjoy it, not because they need to, according to the Fidelity report I blogged about a few days ago.

Similarly, if you are self-employed you cannot really fire yourself, though a lack of work caused by external forces can happen and variations or gaps in income are part of the landscape for most. The self-employed contractors and individual consultants that I know tend to keep a financial reserve to even out cash flow from assignment to assignment. But what follows is mainly about and for those working for an organisation as an employee.

The chances of permanent layoff vary a lot according to a number of factors, as revealed in Stats Can's study Permanent Layoff Rates. Here is a rough summary:

Chance of being laid off within the next year -
  • men 7-8%
  • women 3-4%
Relative to the average, + = higher chance, - = lower
+ for younger people
+ higher paid
++ small firm, i.e. double the chance in a large firm
+ manufacturing (the rising loonie effect)
++ primary and construction industry
- public services
- highly educated

The chances of being laid off changed very little (less than a percentage point) between 1989 and 1999, both good periods for the economy. As the study says but doesn't quantify, layoffs rise during recessions. The study only states the risk of layoff within the next year, not a whole working career, which must be a lot higher. In sum, there is thus a significant chance that a person, on average, will be laid off sometime in their career. The risk is not negligible.

Special circumstances may arise at any individual organisation that can cause a very high risk of being laid off. I'd say that almost always, those periods of threat are very visible to the average employee and are also known many months, often years ahead. In my own case, I have been laid off two and a half times in my career - once, in a federal crown corporation that was abolished through a policy change, which took years from idea to action; once, in the high tech meltdown when the internal rumblings and the external slaughter started 8-10 months ahead of my own walk down the plank, and a half once (through an internal transfer I was able to escape my abolished job), at a municipal government where the council's budget problem was highly public knowledge six months ahead. When those storm clouds start building, don't ignore them!

Cost - The impact of job loss is without question enormous for everyone (again excluding retired people) as one's pay is the largest, most often the only significant, source of income to live on. Take your net pay and that's the effect you will feel. It is thus the multiple to use in figuring how many months - from zero upwards - you will need.

Risk Response -
How long will funding be needed?
Before looking at alternative responses, you need to estimate for how long you might need funding. That's a tough one because getting a new job and ending the emergency depends a lot on how much smart effort you expend on the job search and a little on luck (not the other way round ... remember the quote, ''The harder I work, the luckier I get'' attributed to both film mogul Samuel Goldwyn and golfer Gary Player?) It is possible to be out of work for a year or more. An often quoted rule of thumb is about 1 month of search for every $10,000 in salary. My own two layoffs lasted eight months and zero months.

I'd say a year is the maximum I would consider a job loss emergency to last. Beyond that it's no longer a short-term emergency, it's a major life crisis and much more drastic action than a simple emergency fund will be required - e.g. selling and moving home to a new city, career change. Of course, long term, short term it doesn't matter, one still might need to live without a job income and the possibility of such events is a compelling reason to save and invest money. Retirement isn't the only time in life when a person might want to live off savings.

What sources of funding do you automatically receive? These obviously reduce the need for a fund.
In Canada today, we are lucky to have sources of income support to which we are entitled:
  • severance pay - for salaried workers in a permanent job, there is a rule of thumb of about one month's pay for every year of service, or for unionized workers it is normally stipulated in the labour contract
  • Employment Insurance (EI) - the federal government's program kicks in when your severance expires (i.e. right away if you don't get any severance at all) and if you have worked long enough to meet the qualifying requirements detailed here; only about 20% of people who lose their jobs are ineligible for EI according to this 1999 Stats Can study; some of the key points of the EI program are:
    • two week period at start of no benefits - the deductible
    • max 28 days or less before the first cheque arrives
    • payments last from 14 to 45 weeks
    • pays 55% of insurable earnings (capped at $40,000 p.a.) up to a max of $432 per week
In other words, these two sources might take care of the funding requirement by itself, as it did for me.

Responses -
  1. Reduction of household expenses - most budgets have quite a lot of discretionary spending but of course this is only a partial solution; battening down the hatches is better done once the warning signs appear not when the storm breaks of course
  2. Job loss insurance - some companies in Canada offer interest protection on line of credit borrowing e.g. the Bank of Montreal's Disability Plus Insurance, some offer balance protection on credit cards e.g. TD Visa's, and others mortgage interest payment insurance e.g. Canada Mortgage and Housing Corp's Mortgage Loan Insurance, Reliant Insurance's Job Loss Program or North Shore Credit Union's Mortgage Insurance; you can thereby obtain cover on loans for house and car, which are the most important and largest expenses, apart from food, that any family is likely to have. Job loss is one of the main causes of foreclosures in Canada. You will be obliged to get insurance if you have a high ratio mortgage but if you are not, get it anyway, it's worth it. Apartment dwellers can obtain lease insurance, such as that of Canada Life.
  3. Enhance your own human capital - capital is a store of wealth and just as you can have financial capital you can make yourself a more valuable commodity by constantly upgrading skills, competencies and job experience. Your usefulness is what organisations pay for and instead of waiting for an organisation to direct you, take charge, look around and get going where the demand will be and where you have an interest. You might either avoid layoff within the organisation where you are presently or be able to bail out faster at the signs of trouble. Job loss may then even become an opportunity - a programmer who reported to me was also laid off like everyone else, received his severance and then discovered he could make a lot more money as a contractor, pick the jobs he enjoyed and which enhanced his future marketability. He also made sure to set aside time and money for technical training to make sure he would stay in demand. So much for a need for an emergency fund for him!
  4. Diversify - whether it is having both partners in a couple earning or having more than one source of income yourself, that can reduce the impact of the job loss. Whether it is investing in real estate to rent out, turning a hobby interest into sideline business or something else it is an extra, independent source of income
  5. Family - sometimes mom and dad, or other family members, are able to help out; for some younger singles, moving back home until a new job is found can become the solution
  6. Don't take a job you hate just because it offers job security - you will be miserable every day, that's not what life is about
In short, for a minority (less than 20%), depending on their circumstances, there may be a need for an emergency fund of up to a year to cope with job loss. For me, an emergency fund for job loss has never made sense even though I was laid off twice because I received severance packages and I had other savings by the time it happened.

One big problem is that in practise I would guess those who could most benefit from an emergency fund are the least able to save to have one: younger workers in cyclical, non-permanent jobs.

In anticipation of the discussion on how to provide the fund, one thing I would not recommend in the job loss situation is to rely on a line of credit. Not knowing when a new job will be found and the emergency will end makes the possible accumulation of debt open-ended. There is a limit to what lenders will give out. And it is stressful enough to be out of work without having the worry of a growing pile of debt.

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