Building—and Using—Emergency Savings Helps to Create Lifetime Financial Security

David C. John is a senior strategic policy advisor at the AARP Public Policy Institute. His areas of expertise include retirement savings, pensions, and annuities. This article was originally posted on AARP Public Policy Institute’s Thinking Policy blog.

Emergency savings provide a way for households to meet unexpected expenses without having to take money from retirement accounts, thus helping to preserve those assets for the future. Two recent studies show that having—and using—these emergency accounts also make households financially stronger, and thus able to save more for retirement. This may be why a new survey by the Aspen Institute found that both the private sector and policy professionals believe that retirement plans should also include an emergency savings feature.

Intuitively, emergency and retirement savings are connected. People in serious financial distress are much more likely to either stop saving for retirement or never start in the first place, particularly if they do not have emergency savings to weather challenges. In the United States, the problem is compounded by the fact that participants typically can withdraw savings from a retirement account at any age. Tax penalties and often tax withholding usually reduce the amount the saver receives, but these seldom discourage withdrawals. Thus, a US household’s financial emergency not only affects the ability to save, it often reduces existing retirement savings.

In a recent AARP paper, academics Jorge Sabat of the Universidad Diego Portales and Emily Gallagher of the University of Colorado, Boulder, used the US Census Bureau’s Survey of Income and Program Participation to follow over 21,000 low- to-moderate income households over four years ending in 2016. An earlier paper by the same authors found that liquid savings of at least $2,452, roughly one month’s income, can meaningfully buffer low- to moderate-income households against short-term financial hardship. This is a much more modest savings target than the rule of thumb of three to six months of income. The paper found that savings also help to reduce the chance that households with higher incomes suffer financial hardship, but less dramatically since they are more likely to have access to credit or other resources.

In this study, Sabat and Gallagher found that low- and moderate-income households that had liquid savings of roughly $2,500 at any point during the study period between 2013 and 2016 were significantly less likely to experience financial hardship up to three years later. Controlling for other financial and demographic factors, achieving this savings buffer is associated with a 9.5 percentage point decrease in the likelihood that a household will experience hardship up to three years later. Further, low- and moderate-income high-hardship households that achieved the savings goal at any point in time during the study period had nearly twice the likelihood of improving their financial well-being status to low hardship compared with households that did not achieve the savings goal.

Savings are meant to be used, not just sit in an account. While many researchers and others focus on the total amount saved, “savings totals alone are not a useful indicator of measuring savings success,” according to the Aspen Institute’s Financial Security Program. Instead, the continuing process of building and then using savings is far more important. In short, the value of having a savings balance available goes beyond the ability to cover an emergency expense. The ongoing process of building, using, and then replenishing savings helps protect families from immediate problems while staying on track for their long-term goals.

The implications of this research for the financial industry are as important as they are for individual savers. Retirement plan providers that sponsor payroll deduction emergency savings accounts, either directly or through a partner, make it much more likely that their savers will feel financially secure enough to save more for retirement and to continue to save during periods of hardship. Employers also benefit, because workers who have emergency savings are more productive when they aren’t distracted by financial worries.

However, how the accounts are structured matters. A separate emergency account is more likely to be preserved for that purpose than just adding more to an existing savings account. Money in an emergency account is less likely to be spent on a vacation or something similar. It is possible to add an emergency account onto a retirement platform, but creating a separate and distinct emergency account may be easier and more useful for the saver.

In addition, regulatory obstacles need to be cleared before emergency accounts can reach their full potential. Just as automatic enrollment has been essential to increasing participation in retirement accounts, it is also essential for emergency savings. A 2018 national survey by AARP showed that about 70 percent of US employees said they would likely participate in an emergency savings program. But experiences with emergency savings programs today show that only a small percentage of eligible workers actually sign up. Regulators are expected to allow a trial of automatic enrollment emergency savings programs later this year.

Emergency savings accounts are more than just a good idea. They can help protect households against financial hardship today and enable greater retirement security in the future.


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