Conduct a financial fire drill

What happens to your finances when part or all of your household income disappears? Unfortunately, many people found out the hard way in 2009. Now, more experts are recommending that everyone should have some clear answers to this question.

Enter the financial or fiscal fire drill. The concept isn’t new — Dr. Elizabeth Warren, a Harvard law professor, and businesswoman Amelia Warren Tyagi recommended it in their 2003 book The Two Income Trap — but it has been gaining a lot of attention in the media over the past year.

The idea is simple: Conduct a practice run of your emergency plans so you can spot weaknesses and make changes. While many people have emergency funds or savings to fall back on, they often don’t know how long the money will actually last. They might also be missing key pieces of information — like any benefits or insurance policy pay-outs to which they are entitled.

Financial fire drills tend to focus on job loss, but there are many factors that could affect income — like a pay cut or shrinking income from investments. We also can’t ignore the impact of the loss of a partner, whether it’s due to death or divorce, or the long-term consequences resulting from an injury or disability. Health emergencies (like a heart attack or stroke) and chronic diseases can also affect our ability to work, whether we’re directly affected or need to take time off work to care for someone who is.

How safe are your plans? Here are the steps experts recommend for running a financial fire drill:

Review your resources

It’s good financial advice to keep tabs on your household’s monthly income, but most emergencies involve losing part or all of this income (at least temporarily). Now is the time to look at what other resources you have to fall back on, including:

– Your emergency fund. How much is in your emergency reserve, and what is the cash earmarked for? If your fund includes things like car or house repairs, you’ll need a larger cushion. You may want to adapt your plan depending on your life circumstances, including dependents (parents and children) and changing risks (like an increased risk of disease or falls).

– Additional sources of money. You’d rather not touch them, but what resources could you draw on if absolutely necessary? Are you comfortable touching your investments and RRSPs, or borrowing from credit cards or lines of credit?

– Insurance policies for accidental death or disability (if applicable). What do you have, how much are the benefits worth, when do they start and how long do they last?

– Government benefits to which you may be entitled, like unemployment insurance or disability benefits. If you’re close to retirement age, you may want to consider the implications of taking CPP and OAS sooner rather than later.

What about severance pay and “banked” sick days or vacation days? Find out your employer’s policies before you count on these resources, and beware that in the case of bankruptcy or company failure you might not get anything.

Consider your expenses

How long your money will last will depend on how quickly you spend it. Obviously, when there’s a loss of income some things can be immediately slashed from the budget — like new clothes, saving for a vacation and entertainment. What you need to know is how little you can live on by calculating your necessary expenses — like housing, transportation, food, utilities, medications, etc. (These expenses cover the things you need to survive and work.)

Naturally, there’s some middle ground between what you’re spending right now and your basic needs. It’s unrealistic to expect you can cancel your services and subscriptions without penalty, instantly downsize to a smaller home or sell off your assets or investments for a fair price. (Though these steps may factor into your long-term emergency plan.)

What about debts? An emergency doesn’t excuse you from paying your bills or your mortgage, but you may be able to negotiate with creditors to reduce your payments, or resort to only making the minimum payments instead of paying off extra.

The good news is that you can deduct any employment insurance premiums or remaining income from your expenses. If you’re part of a two-income household, experts recommend running the numbers for the loss of each income as well as for the loss of both at once.

Do the math

Once you have your key figures — how much money you have now and how much you expect to spend — it’s time to get out the calculator and play with some numbers. Basically, you want to divide your emergency fund by your monthly expenses total.

For instance, if you have an emergency fund of $10,000 and you estimate your household’s monthly expenses to be $1500, then your savings will last roughly six months if there’s no income coming in. If you have an additional $9000 available in a line of credit, that can buy you another six months — but you’ll be left dealing with the debt in the long run.

What if you cut back your monthly expenses by another $200? Your emergency fund will last over eight months.

And if you only lose one income, but still have one to fall back on, you might be able to break even or come close to it — but other financial goals like debt repayment and retirement savings will take a hit. An emergency may change your long-term plans, like retiring at a certain age.

Try some variables

Still have the calculator handy? Try running the numbers for a couple of different scenarios. Emergencies tend to generate additional costs, depending on the situation. For instance, finding a new job may require travel, networking, updating your portfolio and buying some new attire. A health-related emergency may require medications, equipment, travel and hotel costs, home modifications and health care not covered by your provincial plan. That $10,000 fund won’t go as far if you have to spend a couple of thousand on unexpected expenses.

It doesn’t hurt to consider a few “what-ifs” here as well — like “What if we had one car instead of two?” or “What if the stay-at-home spouse returned to work?”

Your fire drill can include more than just the numbers. What if the person who handles the investments or pays all the bills is incapacitated? Will another person have the resources and know-how to step in?

Target the weaknesses

Now that you’ve seen the worst case scenarios, you’re either happy with your current plans or looking to “tweak” them to address any weaknesses. The financial fire drill can serve as motivation to trim your spending and boost your emergency savings. It might be a prompt to ensure you’re comfortable with your insurance coverage and investment strategies.

It can also inspire some new goals when it comes to managing your career. If health issues take you away from full time work, could you adapt your career to part time hours instead? Are there opportunities to freelance, consult or pursue other career opportunities?

Of course, the financial fire drill is just an estimate of what could happen. There are no guarantees. As with a fire, the full impact often isn’t evident until after the crisis ends (or is well under way, at least). However, knowing what resources you have versus what your expenses will be can give you a rough idea of where you stand — and what you can do now to make things less stressful later on.

Sources: DrPhil.com, MSNMoney.com, The Consumerist

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