financial safety net

Create an Emergency Fund

Reserve capital is essential for maintaining the wellbeing of your family and optometric practice.

JOHN MCDANIEL, O.D., M.L.H.R.

In these uncertain times, many optometric practice owners are seeing their practice revenue shrink, as families struggle with their own financial difficulties. Yet even in the best of times, the loss of a job, an unexpected legal action and even an unexpected death all have the potential to create a financial catastrophe, and it becomes blatantly clear that every financial entity should have a strategic safety net of reserve capital. (The term "financial entity" has a specific and narrow accounting definition, but in this case I'm referring to families, businesses or individuals.) Your practice is a financial entity as is your family unit. If you need further incentive to create a safety net, Google "subprime mortgage crisis," or "big three car makers."

In my opinion, establishing an emergency fund is the most important component of your financial safety net. A full one third of Americans say they have no emergency savings, according to the National Foundation for Credit Counseling (NFCC). Further, of the remaining two thirds, more than half don't have enough funds to have a meaningful impact, should an unexpected financial hardship occur, the NFCC says.

Here, I explain how to create an emergency fund for your family, with some mention of practice-related considerations. While considerations related to each financial entity are important, given the choice between creating an emergency fund for the home or the practice (assuming you can't do both simultaneously), I believe it's important to safeguard your family first. Of course, some could argue that the practice comes first if you, the optometrist, are your family's sole provider. Either way, you can use the following guidelines to create an emergency fund for your practice or practices as well. (A caveat: Although life and disability insurance play roles in your financial safety net, you shouldn't take into account any potential payout amounts from these entities when determining your emergency fund amount. This is because gaps exist in insurance coverage, and neither is going to cover all "emergencies.")

1. Determine the emergency fund target size

How much is "enough" for an emergency fund? Rules of thumb guide the answer. These rules apply to both personal and business financial emergency funds. The first rule of thumb: Maintain sufficient funds in your emergency savings to cover three, six or 12 months worth of expenses.

The relative stability of your income is the factor that determines exactly how many months worth of funds for living and/or practice expenses is sufficient. The greater the relative stability, the fewer the number of months worth of expenses you must maintain in the emergency fund. Use the following three components of stability to guide your decision regarding coverage for three, six or 12 months.

► Number of income streams in the family unit. Typically, of course, this would be one or two incomes. For some optometrists, however, it may not be this simple. This is because some optometrists derive their income from more than one practice. This has the effect of increasing the stability of the income because of the reduced likelihood that more than one of the practices will cease to contract with or employ the optometrist at the same time. In short, two independent income streams are deemed more stable than one income stream.

Also, it's important to assess the independence of multiple income streams. For example, if a husband and wife both work for the same employer, this decreases the overall stability of the two income streams, as the risk of that employer going out of business, laying off employees or downsizing may be doubly applied to both income streams regardless of who's the higher wage earner.

Finally, I believe you should assume a single income stream for a practice, regardless of how many individual services (i.e. vision exams, contact lens fittings, frame sales, vision therapy, etc.) garner you revenue. This is because a single event, such as practitioner injury or employee embezzlement, can negatively affect all these income streams. Further, while an in-depth analysis of your practice can help you realize additional revenues, this analysis may not be necessary to determine the amount of money you should save in your emergency fund because the emergency fund is based on total income.

In a situation of less than two income streams, or two highly dependent income streams, six to 12 months of cushion makes sense. For situations of two or more income streams, three to six months of cushion makes sense.

► Volatility, or variability, of the income stream. A highly stable income stream is one entirely based on a fixed salary or hourly rate. An example: An employee who earns $70,000 per year without any variation as long as he remains employed. A highly volatile income stream is one that might also average $70,000 per annum but is wholly determined by variable measures, such as commissions or bonuses, among other performance measures.

Classify volatility into one of three levels: low, moderate or high. The number of month's worth of expenses is three for a low level, six for a moderate level and 12 for a high level. If you own one or more optometric practices, use the annual growth rates in gross revenue of each practice to determine income volatility. (See "Categorizing Practice Income Volatility Based on The Growth Rate of Gross Revenue," below.)

► Employment status. This component may help you make a final decision when the first two criteria put you in between two options for duration of coverage. For example, if, upon analyzing the number of income streams, you determine three months makes sense but the volatility analysis suggests six months, you can use the employment status to push your decision in either direction.

When determining the emergency fund amount, I believe that being employed or under contract has a slight edge over self-employment or entrepreneurial endeavors in terms of stability. This is because employment often offers financial safety nets, such as unemployment coverage, the possibility of severance packages and continued insurance coverage. And, if you're contracted for services for a specified rate, you have legal recourse to get the value of the contract — at least to the extent that the contract doesn't reduce this option. While self-employment offers you the security of controlling your own destiny and the opportunity to maximize your income, the aforementioned financial cushions don't exist, should the business fail.

When using this component as a tiebreaker, my personal bias is to take the safest approach, and choose the higher number of months. (See: "Clarifying The Process," below.)

After determining how many months worth of expenses to save, you must determine your monthly expense load. While individual situations vary, the following are examples of expenses that generally pertain to everyone:

► Mortgage/rent payments.

► Utilities. This pertains to gas, water, electric, phone, cell phone and Internet service.

► Auto expenditures. This is related to loan/lease payments, gas, insurance and maintenance.

► Food expenditures.

► Other insurance. This pertains to home and health. Consider that the job that you or your spouse might lose is the one that provides access to health insurance. It's common to assume $500 per month for an individual and $1000 per month for a family for health insurance coverage. Also, remember to check with the employer about continuing coverage at the lower group rates, should the individual (you or your spouse) getting health insurance through the job, lose that job.

► Taxes. This is related to income, capital gains and property (unless included in the mortgage payment).

► Entertainment. This pertains to dining out, bowling, rock concerts, etc. Keep in mind that even in tough economic times, it's unreasonable to assume you'll reduce your entertainment expenditures to nil.

► Unique individual expense categories. This can include specialized medical treatments that will continue regardless of your income/job situation.

To obtain the most accurate numbers, analyze your last 12 months of cash outflows.

The business expenses that you must consider are the fixed expenses. Fixed expenses are those that don't vary as a direct result of the patient flow through the business. This includes rent, utilities, etc. Don't include variable expenses (cost of goods sold, etc.) in the calculation when determining the size of the emergency fund. This is because if the emergency brings the business activity down to zero, the variable expenses will also become zero. The fixed expenses on the other hand don't change and will remain regardless of the activity level of your practice.

To determine your monthly expense burden, add the monthly totals for all the above expense categories, including any expenses unique to your situation. Use the monthly expense burden to determine the total size of the emergency fund. Simply multiply the monthly expense burden by the total number of months needed in the emergency fund. For example, assume a monthly expense burden of $6,000 and a six-month fund requirement. This results in a $36,000 target for the emergency fund.

2. Decide where to put the funds

Once you've determined your needs, selecting the right type of investment for your funds is critical. After all, if you don't put the funds into the proper place, the efficacy of an emergency fund is attenuated. A short list of the most common, but not necessarily the correct, places to save emergency funds:

► Traditional bank savings accounts

► Traditional bank checking accounts

► Certificate of deposit accounts (CDs)

► Home equity lines of credit

► Stock and mutual fund accounts

I've found that the best emergency fund financial vehicles meet each of these three criteria:

► The account maintains a stable core value. The account you select should be relatively risk free. This is important because a financial emergency could arise at any time. Because stock market/mutual fund accounts vary with fluctuations in the equities markets, these financial vehicles fail this first criterion, making them an unattractive option for an emergency fund.

Home equity lines of credit fail this criterion as well. As the current real estate bust reveals, fluctuations in the value of your home will change the actual amount of money you're able to access. In other words, equity levels could drop below the amount necessary to fund your emergency needs. Also, homeowners may pay a premium (the interest rate) to tap this money, which is an extra cost. While the interest rate may be very low and deductible, the tax deductibility isn't an advantage when there's no income from which to deduct. Unfortunately, this could be the case.

► The account is highly liquid. Liquidity is a measure of the speed with which the account can be converted into cash. Highly liquid vehicles include all the varied forms of savings and check-writing accounts, including money market accounts. Any account or investment that can be converted to cash in one week or less is considered sufficiently liquid for the emergency savings account. Keep in mind, however, that liquidity alone isn't sufficient for determining the ideal place for the emergency fund. The fact is that if an account is too convenient to access, it increases the likelihood of unwarranted withdrawals. Traditional bank savings and checking accounts fall into the "too accessible" category.

► The financial vehicle allows your money to earn interest without placing your core investment at risk. Because of the need for liquidity, you want to select an option that won't penalize you for withdrawing funds. If all else is equal, an account with an annual percentage rate (APR) of 2.8% is better than a 1.9% APR account. Again, as part of this return calculation, consider any withdrawal penalties, and choose the account that has none. While in certain situations it might be a net financial positive to have an account with a significantly high rate of return and a slight withdrawal penalty, such is not always the case. If removing funds inflicts no penalty, you can have complete confidence in the value of the account before and after any unplanned withdrawals. Keep in mind that CDs often have early withdrawal penalties and very limited access to the funds. Something else to consider: Traditional bank savings accounts typically fail this criterion because they often offer very little interest, and several require service fees. The same can be said of traditional bank checking accounts.

Other financial vehicle options, such as high-yield savings accounts, money market mutual funds and bank money market accounts meet all the guideline parameters and, therefore, serve an emergency fund account holder well.

High-yield savings accounts are the same as any typical conventional savings account except that, as the name implies, the yield is significantly high. Often times these accounts are Federal Deposit Insurance Corporation (FDIC) insured up to $250,000. However, high-yield savings accounts aren't available to everyone. Banks commonly require one or more of the following before allowing you to open a high-yield savings account with them:

► A large minimum initial deposit, which can vary, but often starts at $10,000 or more

► A high minimum balance, which can vary, but typically starts at $25,000 or more

► A limited number of transactions per time period

► Other bank accounts or business with the institution

Some Internet banks require only minimal initial deposits, no minimum balance and unlimited access to funds. As a result, it's worth comparing the terms of the high-yield savings account your local financial institution offers vs. Internet options.

Unlike mutual fund accounts, which invest in stocks, bonds, etc., money market mutual funds invest exclusively in the money markets. The primary objectives for these funds are to first preserve the principal investment and then produce modest dividends. These funds maintain a value of $1.00 per share by routinely modifying interest rates. Most of these accounts aren't FDIC insured but may be insured via a private insurer.

Bank money market accounts are savings accounts similar to a money market fund. They are FDIC insured and often offer limited check writing. Banks or brokerage firms manage these accounts, which are very safe and very liquid. The interest rates for these accounts, however, may be lower than desired and certainly are lower than those associated with high-risk accounts, such as mutual funds and stock fund accounts.

Several Internet sources and print publications make comparing the many different options available in the above types of accounts easy. A few of my personal favorites: Money magazine, www.bankrate.com, www.bankaholic.com and www.money-rates.com.

By limiting your options to high-yield savings accounts, money market accounts and money market mutual funds, you've left only one variable for consideration: rate of return. Simply put, the option with the greatest yield is the best place to put your money. Note that interest rates change through time, so you should review the options no less than annually and no more than every six months. (Treat emergency funds as long-term investments. As such, reviewing and moving the funds more often than every six months is counter-productive due to fees, likely account limitations, etc.)

After you've decided where to open your account, determine the rate at which you'll build up the fund. While the answer to this question certainly depends on individual circumstances, I generally recommend you build it up as quickly as possible. I often suggest that you redirect at least 80% of your retirement investment to the creation of an emergency fund as long as you're younger than age 55. If you're younger than age 40, I recommend you redirect 95% of your retirement investments toward the emergency fund. However, work with a qualified financial planner to help simplify decisions specific to your personal financial situation.

Considering the current state of the U.S. economy and how it's affecting consumer decisions, there's no time like the present to create an emergency fund for your family and practice, if you haven't already. One caveat: Remember that the emergency fund is for "emergencies" only. A great stock tip or an amazing price on a boat doesn't constitute an emergency. The more conservatively you handle your emergency reserve, the better it will serve you down the road. OM

Dr. McDaniel is president of Waugoo Consulting Group, a national healthcare practice consultancy organization that has assisted practice owners in getting their financial situations in order. In addition, Dr. McDaniel has used these steps to manage his own emergency fund. E-mail him at JMcDaniel@waugoo.com.