Sound the Alarm – It’s Time for a Financial Fire Drill

A couple weeks ago a tornado was spotted close enough to sound the alarm, sending us running for cover. It reminded me that every now and then it’s a good idea to review emergency procedures at home, work and school.

As usual, I thought about how this related to personal finance. Shouldn’t we periodically review how prepared for financial emergencies? Consider the scenarios.

How long could you survive if you or a spouse lost your job? What if you are like me and are the sole income provider – how long could your family live on savings alone? Could you sustain a 6-month period of no income due to a medical disability? If you are not sure about the answers to these questions it is probably a good idea to conduct a financial fire drill.

Steps to Planning 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.

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 in 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, XM radio 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. Our goal for an emergency fund is to have one year of basic household expenses stashed away.

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 health insurance 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.

Comments

  1. In the event of a fire, my ‘investments’ folder would have to be one of the first things taken from the house, and I had never really thought of that before reading this post. (I always thought about photo albums and other ‘memories’.)

    Great post.

  2. Good tips. Also…regarding your major medical deductibles…Some plans have a single deductible for the entire family and others have individual deductibles. It’s always wise to know which you have before a major event occurs.

  3. Definitely check the COBRA. My sil just got out of the Marines. COBRA was “only” $605 a month- but it had to be paid UP FRONT in a three month block. A family who makes $18,000 a year might have a difficult time pulling $2000. out of their pocket!
    You have excellent tips- especially the numbers of non essentials. I will be putting that together today.

  4. Really good post.

    It’s imperative to do this sort of assessment on a periodic basis. I think many people don’t realize the costs that could come out of dealing with COBRA. It can be sobering. I encourage people to always keep that in mind when considering emergency fund/loss of income type of situations.

  5. This is such a great idea, and I think every family needs to do this. What happens in the event of an emergency? You can’t just say “welp, time to turn to the emergency fund”. You need to cut things out, know how long you’re prepared to be in that situation, and know where to turn next. This is something I’m going to implement because you just never know, especially in this economy.

  6. Since my company had a history of doing layoffs every 18 months or so, I tended to do this type of thing everytime the layoff rumor mill started buzzing.

    I didn’t think about added expenses..like cobra. I also have a car and a cell phone that’s also paid through work, so that would be an additional expense that I didn’t always think about.

    The last time I did this, I realized I had way too many fixed expenses and not enough slashable ones, so that’s what I have been focusing on reducing the last couple of years. For example..daycare, cable, gifts, vacations and eating out are easily slashable expenses..mortgage, taxes and insurance are not.

  7. Cobra is “only” $605 a month? Gee I’d love to pay that. Our insurance has been $800 to $1,200 our whole married life and that is after his work pays some of it. Right now we pay $900 on an $1,200 plan. That is hardly much more we’d have to pay if he lost his job.

    Eating out would be an easily slashable expense for us but we have hardly any of this type of expense. We don’t have cell phones or cable. We do have Internet because I depend on it for communication since I’m deaf. Gifts are very minimal costs for us because we tend to give useful things that we got free with drugstore deals and rebates. So we can easily give what looks like a $30 to $50 gift and pay maybe $2 for all the stuff.

    If we scrimped like we did when we first married and utilized food pantries and just bought milk and some produce items we could probably make it for 15 months or more on our current savings. This is assuming we have no extra income, which I would expect if hubby lost his job we would still get unemployment at least for awhile. So taking that into consideration and that my disability covers our current rent…if our expenses didnt change our big and most important current expense is covered by me.

    • I guess you hit some of the major things why your insurance is so high. My daughter is 26 and husband is 22- with a healthy 2 year old. No long term problems. Your COBRA would probably be much higher as well- since it is based on what you –and your company— pay for you each month.
      My sister in law (over 50) paid well over $1200 a month for health insurance- but she is my age and has had three bouts of cancer. Their COBRA was about $1600 a month when my brother in law was laid off.
      I will be glad when everyone can be covered reasonably.

  8. Being unemployed nowadays without too much savings on your bank are a hard situation to bear and handling our finances while we have a job has no difference. But the fact that learning to save money while we can is a big thing. I always do the math and same as you we only buy the things we need and do not exceed on the budget as much as possible.

  9. Savings should be higher if you are self-employed because you will NOT be eligible for unemployment! My husband is self-employed, so we are looking into personal disability insurance as another way to mitigate risk.

  10. You spell out good tip on holding financial “fire drills”. I have never done it with my faimly. I would guess you will really find out whether you would have enough saved money to deal with any financial crisis.

  11. Disability insurances is one of those you desparately need if you need it, but hope you never have to. Thankfully, hubby and I both have disaiblity through our employers. If you are self-employed, you probably really want to look at this.
    My hubby (main provider) had a brain aneurysm 2 years ago. His disablity insurance kicked in after 7 days, and it was less than 100%, I think it was 75%. But it was awesome to not have to be stressing about money while we are concerned with his health and recovery. (btw, he came out absolutely fine! a miracle!)
    Now I am in the middle of a medical leave due to stress, depression and anxiety. I also have disability insurance but am having to fight to appeal for benefits. I believe it will be approved, but I am having to push for it. We are able to survive without my income, but it was our cushion, our savings, vacation and holiday money. Hoping for approval in the next week or 2 or it will be a VERY LEAN Christmas!
    Also just remember that all disabily policies have different terms, be sure you know what you are getting if you have to purchase your own. Most do not pay 100%, and the amount may decrease after a period of time. There is also documentation that may be necessary depending on your medical situation.
    Here’s to hoping you have it, but never need it!
    Bernice
    http://livingthebalancedlife.com/2010/what-are-you-focusing-on/

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