Over the years there have been more than a few occasions that the government has shut down due to a fight over funding for various reasons in Congress. Since 1980, there have been no less than 10 times that a government shutdown has occurred. Unfortunately, when these shutdowns happen there is a chance that federal employees, contractors and military members don't get paid. This can cause a tremendous amount of financial strain for those people who find themselves either furloughed or having to go without pay.
Thankfully, there are some tried and true strategies military members and federal employees can use to insulate their financial lives so these political fights don't cause undue financial hardship for them and their families. Let's review what you can do to prepare your finances for a government shutdown or other financial emergency.
Risk Mitigation Principles
When I was in college getting my MBA one of the concentrations I earned was in competitive strategy. One of the essential lessons I learned about strategy was to ensure that you identify risks and mitigate them. This was a lesson that I got real world exposure to during my time in the military. After all, no mission was conceived without a risk mitigation plan being developed alongside it. Your financial life is no different.
Identifying Risks
The first principal of risk mitigation I learned was identifying risks.
When it comes to our financial lives, one of the most disruptive events are scenarios in which we lose our jobs or pay, even temporarily. This is because that for the vast majority of us we have contractual commitments or family obligations that require us to pay out a certain amount of money each month. Among these expenses are things like mortgage/rent payments, utilities, grocery store bills, car payments and insurance premiums. Failure to pay anyone of these bills could result in unfortunate consequences.
Estimate the Probability and Duration of a Risk
The next principal I learned about risk mitigation was to estimate the probability and duration of the risk.
According to a longitudinal study by the Bureau of Labor Statistics (BLS), during the course of a person's working career the average number of spells of unemployment was 5.9 times between the ages of 18 and 56 (38 years). However, the unemployment spells varied by educational attainment with high school dropouts experiencing 8.1 spells, high school graduates experiencing 6.5 spells and college graduates experiencing 4.4 spells. We also know from recent BLS data that the median time of unemployment is about 9.8 weeks with the average skewing to about 24.3 weeks.
This gives us a framework to assess the probability and duration of the risk of becoming unemployed in any given year. For example, if we take the average person, we can reasonably say they have a 15.79% chance of experiencing an unemployment spell in a given year (5.9 spells / 38 working years). We can also reasonably say that the period of unemployment will likely be between 2.2 months (9.8 weeks) and 5.4 months (24.3 weeks). So, for the average person, there is a low to moderate chance they spend 2.2 to 5.4 months unemployed during any given year.
Identify Risk Severity
The next principal is to identify the severity of the risk.
For most people, the prospect of going without pay for one pay period is unnerving but the idea of going without pay for 2.2 to 5.4 months is a nightmare. When measuring the severity of financial risk, it is common to identify what value is at risk to you and your family. For example, you might measure how long you can go without pay before you need to start selling assets or going into debt to maintain a minimum level of spending. A person might attribute different levels of severity to different assets they must sell. For example, selling a car may represent a moderate level of value at risk, but selling a house might represent a critical level of value at risk.
The question of how you prioritize the severity of risks and measure the loss of value is often a mix of quantitative and qualitative measures. A house will usually have a dollar value associated with it but it may also represent a home with fond memories that live within it. However, a car, although valuable in its own right, is usually much less likely to have as much qualitative or sentimental value attached to it.
Mitigating Risks
Some of the best risk mitigation strategies for going without pay for long periods of time include:
- Implementing a robust savings rate while working. A high savings rate means a low expense rate so when a loss of income event occurs the severity is relatively less critical.
- Increased educational attainment. As the data from the BLS clearly shows, increased levels of education are associated with fewer unemployment spells.
- Maintaining a separate account that is earmarked as a cash buffer for financial emergencies.
One of my favorite strategies is the simplest strategy, maintaining a large cash buffer for financial emergencies. It is simple to understand even though it takes time and discipline to enact. However, picking the right amount of cash to target for your cash buffer can often be a difficult decision. I think the best approach is a custom approach that takes into account a person's or family's unique circumstances and lifecycle stage. For example, a military member in their late teens or early twenties might still be living on base and eating at the DFAC at no out-of-pocket cost. For this person a larger cash buffer seems to be inappropriate because there is less real value at risk for them if they don't get paid during a shutdown or when a financial emergency pops up. However, someone who has already transitioned out of the military and is in their second or even third career may have a mortgage and a family to provide for. This person has a tremendous amount of value at risk when they stop getting paid.
I like to use an escalating lifecycle scale for targets for a person's cash buffer and adjust those targets up or down based on individual circumstances. Here are standard lifecycle targets for what size cash buffer a person might benefit from:
- 20's: 3 months of cash reserves
- 30's: 6 months of cash reserves
- 40's: 6 to 12 months cash reserves
- 50's: 12 to 24 months cash reserves
- 60's and up: 24 to 36 months cash reserves
Using this escalating lifecycle scale is a great way to reflect the increasing amount of financial responsibility a person attains throughout life. It also has a natural culmination in retirement when a person shifts from earning a living to living off their earnings. When a person reaches the point that they no longer have the prospect of earning an income, a higher cash buffer is a smart strategy because they need to mitigate the risks of having to sell out of their portfolio during a down market when a financial emergency rears its ugly head. As with so many other areas of life, Murphey's Law reigns supreme.
While these are general targets to consider they are not going to be appropriate for many people because different people will have different circumstances even within the same lifecycle stage. For example, a person with a paid-off home may not need nearly as much of a cash buffer relative to their income because their expenses are relatively low. Likewise, someone with a military pension or VA disability compensation may be able to get by without a paycheck more easily because they are likely still receiving some form of income.
At the end of the day, having a conservative and well thought out cash reserve target is instrumental in mitigating the risks associated with a government shutdown or other financial emergencies. While the concepts are simple, the discipline required to keep your emergency money separate from your normal accounts and spending over the course of your life can be quite challenging. That is why it so critical to review your income, spending and savings on at least an annual basis to make sure you are on target and prepared to weather the next financial emergency or government shutdown.
Want to review your cash reserves and create a savings plan?
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Disclaimer: This blog post is intended for educational purposes only; it should not be construed as tax advice or financial planning advice. Consult a professional for tax and financial planning advice before making any changes. All photos are from open-source domains, generated by artificial intelligence or are the property of Stars & Stripes Financial Advisors.