How To Conduct A Financial Fire Drill

Do you know how long you could survive if you or a spouse lost your job? What if you are like me and are the lone income provider – how long could your family live on savings alone? If you are not sure about the answers to these questions it is probably a good idea to conduct a financial fire drill.

The concept of a financial fire drill is based on the idea behind a real fire drill. It allows you to run through a real emergency before you have to act with smoke and flames. In the case of a financial fire drill, this means you will simulate a “what if” scenario so you’ll know what to do, and what things need to improve, before a real life financial emergency strikes.

Steps to Planning a Financial “Fire Drill”

1. Include the entire family. My family has a pretty good emergency plan. We all know where to meet in case a fire separates us in the middle of the night. We have a rendezvous point established for larger-scale emergencies, and even the kids are aware of actions to take based on various types of disasters. Similarly, the entire family should also be involved with a financial fire drill.

2. Gather a list of necessary expenses. These expenses are absolute necessities, so things like mortgage payments or rent, basic utilities like water, power, etc. (cable and Netflix memberships don’t count), and other basic expenses related to food, shelter, prescriptions, etc. Nothing else matters at this point.

3. Determine how much is in your “extended emergency fund.” A basic emergency fund is a pile of cash stored in an online savings account or local credit union. A typical goal for emergency funds is to save six months of household expenses just for emergencies. However, in a large emergency such as a job layoff or medical disability, you could likely tap other resources. Be sure to include any stocks or mutual funds not held in retirement, CDs (even if you had to pay a penalty), bonds and any other assets that could be converted to cash quickly. This total amount will represent your “extended emergency fund.”

4. Determine your maximum survivability (in months). Divide the amount of your extended emergency fund by the total expenses identified in step 2. This number represents the months you could survive without an income. For instance, let’s assume an average family of four needs about $2,000 a month to cover their mortgage, basic utility payments and food. If the same family has a $17,000 extended emergency fund, they could expect to make it about 8.5 months on savings.

5. Adjust for increased expenses. Unfortunately, expenses don’t always go down in an emergency. In fact, they rarely do go down, despite your best efforts to cut expenses to the bone. Things like continued health insurance premiums under COBRA, or other medical expenses, can cause spikes in spending categories otherwise in check. Make adjustments to your prediction based on these estimates. To show how much impact these “surprise expenses” can have, in our example above the same family could only survive five months or so with a $1,000 COBRA premium added to their $2,000 in household expenses.

6. Conduct a financial fire drill regularly. Armed with all the facts and figures required, it’s time to pull the alarm and practice getting out safely. Since laying yourself off is not exactly a smart idea, it is sufficient to simply pretend you just received your last paycheck. What expenses would you immediately target to be cut? Write them down, along with customer service phone numbers and terms. Repeat this exercise once a quarter or so and update your list accordingly.

The day you are laid off you may grab your list and make phone calls to the newspaper subscription department, your gym, your lawn service guy, Netflix, and the cable company. These moves alone could save you a couple hundred dollars a month in expenses not necessary to your survival, preserving precious emergency funds. Keep this list handy, and only break it in an emergency.

None of these steps will happen on their own. You must be proactive. Force yourself to sit down and run the numbers. If you don’t know how much COBRA might cost, find out. If you don’t know how much your health insurance plan’s deductible is under a major medical event, find out. Don’t wait until your exit interview to discover these new costs. Doing so would be like waiting until smelling smoke to map out an escape route.

This article appeared in the Frugal Living Blog Carnival on 9/4/2009

Comments

  1. I really enjoyed this article. It’s a great how-to prepare for emergencies. I’m adding it to my ever-growing list of things my fiance and I need to do.

  2. Shouldn’t a person also factor in the likelihood that only ONE income will be lost at a time? What I mean is, it is HIGHLY unlikely that both my wife and myself would be laid off at the exact same time. So for example, if I based an emergency fund on losing my income (the larger of the two right now) then shouldn’t I subtract my wife’s earnings from the total figure of required expenses?

    In other words, if our MUST HAVE expenses total up to 3,000 a month and my wife brings home 1,500 then shouldn’t my emergency fund equal six months of 1,500?

  3. @Michael: Yes, in your scenario that’s probably a safe assumption. I only ran the numbers for a single-income family since that’s what I relate to. And don’t count out the idea that you and your spouse could lose jobs at the same time, particularly if you are in an unstable market, or work in the same industry. It’s a worst case scenarios, for sure, but sometimes it is a good idea to plan for those, too. Thanks for your comments.

  4. What is the best way to find out what your COBRA payment would be without making your employer think you’re about to quit?

  5. @Dee: Great question! Ask your employer for a benefits plan document. Most plan documents list both the employer’s portion of health care premiums and the employee-paid portion. An average family plan might list $650 as paid by the employer, and $350 covered by the employee. If you lost your job, you’d be responsbible for both sides of the premium ($1000), minus any reductions under current legislation to reduce the cost of COBRA. I certainly wouldn’t count on any such reductions when planning your emergency fund.

  6. Saving for 6 months of expenditures seems like quite the goal. I always heard 3, but this recession has certainly outlasted that plan. Six it is!

  7. @RB: Like most things, it depends. I would share things with teens and older children, but keep things light with younger kids. I don’t like the idea of subjecting small kids to worries about money – plenty of time for them to worry about it later!

  8. @Craig: I suggested running through your list of “necessary expenses” and potential items you could cut in an emergency about once a quarter. Any more frequently might seem obsessive, and any less would leave you without an up-to-date list.

  9. @frugaldad With a new roommate moving in at the end of the summer, feel like that will be a good time to figure out what I can cut in the apartment and not re-subscribe for.

  10. I would throw one additional thought into the mix here: Look at what expenses you would immediately cut / reduce if the income were to drop. For example, are you able to terminate the cable TV service or are you under a long-term contract? What about gym memberships, etc? Knowing what to do here can help stretch the dollars available in the emergency fund.

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