Personal Finance
Emergency funds are a ‘security blanket’ for 401(k) savings: Vanguard
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Setting aside money in a rainy-day fund can bolster households’ retirement prospects down the road, especially for hourly workers with inconsistent income streams, experts said.
Emergency funds are a “security blanket,” said Fiona Greig, global head of investor research and policy at Vanguard Group, an asset manager.
That’s because they offer a cash buffer for people who might otherwise raid their 401(k) accounts to pay for unforeseen expenses in the short term, she said.
401(k) investors with at least $2,000 of emergency savings are less likely than those without rainy-day funds to tap their retirement plans early, according to new Vanguard research.
Specifically, they are 19 percentage points less likely to take a 401(k) loan and 17 points less likely to withdraw 401(k) funds for a financial hardship, Vanguard found.
Leaving a job is another trigger that allows workers to access their 401(k) savings before retirement age. Job-switchers who have emergency funds are 43 percentage points less likely to cash out their 401(k) accounts than those without, according to Vanguard.
“Emergency savings protect retirement savings,” Greig said.
Retirement savers with emergency funds also save a greater share of their incomes — 2.2 percentage points more — in a 401(k) relative to those without them, Vanguard found.
401(k) ‘leakage’ is a large concern
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Policymakers view so-called “leakage” from 401(k) plans — especially cash-outs — as a big impediment to retirement security.
Withdrawing 401(k) assets early generally comes with tax penalties and shortchanges investors, who forgo years of investment earnings on withdrawn funds, experts said.
There would be roughly $2 trillion of additional savings in 401(k) plans over a 40-year period if workers didn’t prematurely cash out their accounts, the Employee Benefit Research Institute estimated in a 2019 paper.
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Leakage is an especially large concern for hourly workers, Vanguard’s Greig said.
Hourly workers are less likely to have emergency funds and more likely than salaried employees to tap their 401(k) savings early, Greig said.
(That’s not just because hourly workers also tend to be lower earners, she said. The trend persists even when comparing hourly and salaried workers with similar incomes, according to Vanguard’s research.)
Hourly workers have more volatile incomes, Greig said. Without an emergency buffer, they may need to tap their 401(k) if cash flow decreases unexpectedly, she said.
How to build an emergency fund
Ideally, households would set aside enough money to cover three to six months of expenses (like a mortgage and groceries) in an emergency fund, said Carolyn McClanahan, a certified financial planner based in Jacksonville, Florida, and a member of CNBC’s Financial Advisor Council.
However, for households barely making enough to make ends meet, anything helps, McClanahan said.
Financial planners generally recommend stashing an emergency fund in a conservative, liquid account like a high-yield savings account or money market fund, which earn more interest than a traditional bank checking account.
Cash-strapped savers can start by diverting as little as perhaps $10 to $25 per paycheck into an emergency fund, McClanahan said.
“Let it grow and before you know it that money will be worth something,” she said.
Workers should automate the savings, either by asking their employer to send a certain amount to their designated emergency account each pay period or by setting up an automatic transfer from their bank account, McClanahan said.
Workers should also strive to save at least half of any financial windfall like a bonus or tax refund, she said.
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