MAKING SENSE -- June 26, 2013 at 5:06 PM ET
Why You Need an Emergency Fund, and Where's the Safest Place to Invest It
I-Bonds are still the safest investment for your emergency fund, argues Zvi Bodie. Photo courtesy of Peter Dazeley via Getty Images.
Paul Solman: Boston University finance professor Zvi Bodie has long touted the virtues of inflation-protected investments on the Making Sen$e Business Desk, most recently when he extolled the virtues of I-Bonds here in May.
That post of Zvi's prompted a response from energy expert Hilton Dier III, which we posted earlier Wednesday.
Given the attention being paid to Americans' inability to salt away enough money for their futures, including our own spiffy retirement tool, "New Adventures for Older Workers," and Ann Carrns' column in Tuesday's New York Times, "Why It's Hard to Build Emergency Savings," I thought it only fair (and, presumably, interesting) to let Zvi re-post (or, for you fencing fans, riposte), responding to Hilton, and to another one of our readers, Bill Presson of Honolulu, Hawaii, who recently emailed:
"I have funds that I like to keep relatively "liquid" in a Vanguard Prime Money Market Account currently paying nearly zero interest. Do you know of other options that would be relatively safe and liquid, but paying more interest? Thanks!"
Zvi Bodie: I agree that buying a cost-saving device can be a very profitable investment whether the cost savings are in spending on energy, storage, communications, physical fitness or other categories of home maintenance or consumer durables.
But most investments in these categories differ from I-Bonds in several ways:
They are investments in real assets rather than financial assets (a distinction covered in my textbooks in the first chapter). Real assets are usually much less liquid than financial ones. They often have limited resale value; they depreciate over time because of usage and obsolescence. In order to overcome depreciation, they require spending on maintenance and upgrades. These costs are never risk free even if the saving in energy costs is.
Even if they are certain, the cost savings only apply to owners of homes and businesses.
They are not contractually linked to the Consumer Price Index (CPI) or guaranteed by the U.S. Treasury.
In my previous post, I explained that U.S. Series I Savings Bonds (I-Bonds) are the safest way for Americans to invest their money for the long run because they are guaranteed to protect the purchasing power of your savings for up to 30 years, no matter how high or how low the rate of inflation in the future.
Most financial experts advise that before you start investing for retirement, or any other long-term goal, you should create an emergency fund that is invested in safe, readily accessible assets. For example, the website of the Financial Industry Regulatory Authority (FINRA) advises people as follows:
It's also important to set aside some money--about the equivalent of 3 to 6 months' of living expenses--in an emergency fund. There are times when people become ill or are injured in accidents. Employers lay off workers. If something unexpected happens to you, having the money you need to pay the medical bills or see you through the weeks or even months of being out of work will help to keep you out of debt. If you already have investments, an emergency fund also will help you meet your expenses without disrupting your investment plan.
The best place for your emergency fund is in a liquid (easily accessible) account. A liquid account might be a regular savings account at a bank or credit union that provides some return on your deposit, and from which your funds can still be withdrawn at any time without penalty.
To earn a slightly higher interest rate, some people choose a CD for their emergency fund, or a series of CDs of approximately equal value, with one maturing every six months or every year. This approach is called laddering. You can roll over the CDs as they mature, to keep your ladder intact. The loss of interest you face for taking money out early may motivate you to keep your fund intact. But in a real emergency, the interest you may lose is a small price to pay for having the money you need. And if you have to spend any of the money, you should plan to replace it.
You might also consider buying U.S. Treasury bills with some of your emergency fund money. They, too, can be timed to mature on a regular schedule and, like CDs, they tend to pay more interest than a simple savings account. And while they aren't bank products, they are backed by the federal government. That means there is no risk of losing principal if you hold them to maturity. U.S. Treasury bills have very short terms--4 weeks, 13 weeks, or 26 weeks.
Other options for an emergency fund include money market mutual funds. A money market mutual fund is a mutual fund that must, by law, invest in low-risk securities, such as government securities and certificates of deposits. Compared with other types of mutual funds, money market funds are highly liquid, low-risk securities. Unlike money market deposit accounts, money market funds are not federally insured. While they are intended to pay dividends that are comparable to prevailing short-term interest rates, they can lose value.
I agree wholeheartedly with this advice and with the reasoning behind it. What it fails to do, however, is explicitly recommend Series I Saving Bonds as the preferred asset class for your emergency fund. I will explain why I-Bonds are the best place to hold your emergency reserve funds.
By definition of the purpose of the fund, you might need to cash it in on short notice. With I-Bonds, you have immediate access to the cash after an initial holding period of one year from the date of purchase. You need only go online and click a few times to transfer the accumulated value in your I-Bond account to your bank checking account.
If you need the money within the first five years of the purchase date, there is a slight penalty for early withdrawal: You will forfeit the last three months of interest; that is, you will receive your initial principal plus all the accumulated interest up to three months before the date of redemption. However, if you cash in after five years, you will receive all accumulated interest right up to the month of redemption.
Any money invested in I-Bonds is guaranteed by the U.S. government not to lose any of its purchasing power (before payment of income tax on the interest earnings).
Every month after your initial purchase your account will earn an interest rate equal to the initial fixed rate plus the annualized rate of inflation during the preceding six months. Moreover, if there is deflation during any month, you will not be penalized by a drop in the value of your account. Thus, not only do you have inflation insurance, you also have deflation insurance. That is not true of any other asset in which you can invest; It is a unique feature of I-Bonds.
The interest earned from I-Bonds is exempt from state and local taxes, and federal taxes are due only when you cash in the bonds.
If used to pay for educational expenses, the interest earnings may be excludable from your taxable income. Thus, you may never have to pay any taxes on the earnings.
If you have very few financial emergencies, you may never have to touch the fund. The maturity of I-Bonds is 30 years, and you may wind up holding them until maturity. The inflation-protected I-Bond account will then be available to provide retirement income.
The tax advantages of I-Bonds do not require that they be held in an IRA or other special retirement account. If purchased for retirement, the interest earned will be taxed at your tax rate during the retirement years, meaning I-Bonds are an excellent way to hold your safety fund at any age.
Because you get the tax deferral and other tax benefits of I-Bonds without holding them in a retirement account, if you redeem the bonds before age 59 1/2, there is no 10 percent penalty charge on the amount withdrawn that you would face with an IRA or 401 account.
Now let us look at the actual rates of interest that you would be earning now, if you had purchased I-Bonds in each of the years since they were first issued by the U.S. Treasury.
Table of current interest rates being credited on I-Bonds purchased in May of each year. I-Bonds were first issued in September 1998. For subsequent years, the fixed rate is for May. Information courtesy of U.S. Treasury.
Click on the graph below to see a larger image.
Annualized total I-Bond interest rate for each bond is the fixed rate that prevailed in the year they were purchased plus the most current annualized inflation rate of 1.18 percent.