A Fragile Balance

Emergency Savings and Liquid Resources for Low-Income Consumers

J. Collins

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137482372
• Topic: Business
• Subtopic: Financial Services
• Index: Business

A Fragile Balance examines strategies to promote emergency savings, especially among underserved households. Each chapter is by an expert contributor and proposes an innovative financial product or service designed to bolster emergency savings among low-asset families. This collection also offers readers insights into the role of emergency savings and mechanisms to facilitate savings behaviors, and raises critical questions of the scale, institutional capacity, sustainability, accessibility, and effectiveness of existing programs.

Chapter 1

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Paying for the Unexpected: Making the Case for a New Generation of Strategies to Boost Emergency Savings, Affording Contingencies, and Liquid Resources for Low-Income Families

J. Michael Collins

Introduction

Low-income households’ accumulation of liquid savings is an important and growing issue, and one that has not yet attracted significant attention in the United States. Financial advisors commonly recommend that people have three to six months of income as liquid savings, stored as cash, demand deposits, or other funds that can be accessed within a few days. This rule of thumb is based at least in part on the fact that it could take three to six months to find a new job in case of unemployment, and liquid funds can provide an emergency safety net for this period (Chang, Hanna, and Fan 1997). However, for lower-income families, a three-month savings cushion is difficult to accumulate. As these households face lower incomes and higher relative costs for housing, transportation, food, and other essentials, just making ends meet is a challenge.

In surveys, low-income households report being worried about their ability to respond to financial emergencies (Lusardi, Schneider, and Tufano 2011). It is important to note that “emergencies” encompass a wide range of situations, not just job loss. For low-income households, even relatively small unexpected expenses can have significant impacts on financial stability (Abbi 2012). A lack of resources can result in material hardships such as housing instability or food insecurity (McKernan, Ratcliffe, and Vinopal 2009). And a lack of financial flexibility can leave households unable to take advantage of opportunities for upward economic mobility, such as job training or enrichment activities for children. In fact, “emergency savings” might better be labeled “contingency savings” since it is a pool of resources used to manage unexpected, extraordinary expenses that current income cannot accommodate.

Without savings, low-income households may have no choice but to turn to credit to make ends meet. For example, Babiarz, Widdows, and Yilmazer (2013) show that households, especially low-wealth households, take on debt following an illness or health difficulty. Demand for short-term, high-cost credit suggests an underlying need for liquidity. In theory, this sort of borrowing is a reasonable substitute for savings. However, emerging research suggests that using high-cost credit could make families worse off overall, relative to using other forms of financial support or savings (Carrell and Zinman 2014; Melzer 2011). Emergency savings may not just be a recommended practice among financial experts; it may actually have a material impact on the quality of life of low-income families. In fact, Xiao (2013), in a broad review of literature, concludes that having an emergency fund is a key factor in overall financial satisfaction and well-being (see also Gjertson, this volume). Yet, low-income families lack much in the way of savings of any kind, including savings to cover unexpected expenses or income shortfalls (Scholz, Seshadri, and Khitatrakun 2006).

The Failure of Precautionary Savings for Low-Income Families

In a review of the literature, Chase, Gjertson, and Collins (2011) identify studies on emergency savings and alternative sources of liquidity for households in times of unexpected income shortages or expenditure shocks. About 30 of these articles focus on forms of precautionary savings, and 5 focus specifically on emergency savings. This set of papers highlights the emerging interest in this area among researchers and policymakers, as well as its potential for growth as an area of study.

The economics literature generally defines savings as the accumulation of financial assets to store resources for future consumption—that is, the intertemporal substitution of income now for income later. These might be in the form of long-term savings, such as a retirement account, or more liquid funds to provide short-run consumption smoothing. This form of savings is unrestricted in its use but intended to accommodate variability in income and expenses. The life-cycle hypothesis commonly used in economics (Ando and Modigliani 1963) suggests people will save less (and borrow more) when their earnings are lower relative to their future earning potential. This implies that younger people with expectations of income growth will save less and borrow more, using their future income to pay down debt. In old age, as incomes decline, people tend to consume savings. Likewise, people will recognize that if they have short-run fluctuations in income, they should save in peak earnings periods to prepare for less prosperous periods.

Saving for a potential income loss is the focus of studies of precautionary savings. Researchers often focus on savings that households accumulate based on expectations of future income losses. For example, Lusardi (1998) finds that people who have a higher risk of an income decline save more than those with more stable incomes; for example, individuals who work on commission may save more when their income is relatively higher to prepare for future periods when income could be lower. In the aggregate, households also respond to income uncertainty by increasing savings as the risk of an income shock rises, consistent with research findings regarding precautionary savings motives (Wilson 1998).

Acs, Loprest, and Nichols (2009) examine within-year income changes among individuals age 25–61 in families with children. They find highest incidence of substantial income declines (50 percent or more) among those initially in the lowest income quintile. Yet, savings levels are substantially lower for these households. Like all forms of savings, precautionary saving levels rise with income (Guiso, Jappelli, and Terlizzese 1992), and lower-income households save relatively less in precautionary funds. Thus, while overall savings is related to households anticipating income drops, low-income households often have little or no liquid reserves. The group that might most benefit from precautionary savings lacks access to that resource.

Precautionary savings can also be defined as funds stored in anticipation of increases in expenditures, in addition to anticipation of declines in income (Nocetti and Smith 2010; Feigenbaum 2008; Browning and Lusardi 1996; Hubbard, Skinner, and Zeldes 1994a, 1994b). However, income shocks appear to be more widely studied than expenditure shocks (Gorbachev 2011). In part this is because there are a wide range of expenditure shocks—including medical costs, the costs of repairing or replacing durable goods, and other expenses that are outside of typical spending patterns. Most households will incur variable expenditures for which the exact timing is difficult to predict, such as car repairs, heating bills, or home maintenance expenses. Other expenditure shocks, such as medical expenses not covered by insurance, changes in family size or status, support for relatives, and costs of relocating or moving, are less predictable but can be large in magnitude. Even households who do not anticipate income drops may therefore prefer to have emergency savings to protect against some form of an expense shock.

Using data from the Survey of Consumer Finances, in which respondents were asked to estimate their own “optimal” savings amounts, Kennickell and Lusardi (2004) find that the vast majority of households report they in fact want to have precautionary savings funds. However, when subjective estimates for desired savings are compared to how much households report actually saving, it becomes evident that many households, particularly low-income households, are far below their stated savings goals. Furthermore, the amounts households say they need often fall below their actual emergency spending; Brobeck (2008) finds that among the lowest income quintile, households perceive annual emergency savings needs at about $1,500, yet these households typically spend around $2,000 on emergencies each year. Very few households approach even the perceived amount required; less than half the households studied by Kennickel and Lusardi (2004) had savings accounts, and less than half of those with a savings account had emergency savings of at least $500. It appears low-income families would prefer to save more but often fail to do so.

It is important to note that smaller irregular spending or income shocks might have amplified effects on lower-income families. A low-income family may be forced to cut back on essential expenses, while a higher-income family can reduce nonessential expenditures. Thus, poorer families may be more profoundly affected by a lack of emergency savings. Lack of liquidity can result in substantial and tangible hardships that threaten family well-being.

The Increasing Need for Emergency Savings

Increased volatility in both income and expenditures have heightened the need for precautionary savings among low-income households in recent decades. Gottschalk and Moffitt (2009) show increasing variance in income over the last few decades, especially for low-skilled, lower-wage workers. Dynan, Elmendorf, and Sichel (2012) also find that low-income people today face a greater likelihood of a drop in income than did prior generations. This change is due to several factors, including welfare reform that has reduced income supports, an increase in part-time employment, the decline of labor unions, and the greater use of contracting by employers. These factors, combined with shifts in demand for both skilled and unskilled labor in international labor markets, mean that low-income households need to be prepared for greater income shocks than in prior generations.

Gorbachev (2011) shows expenditures have also become more volatile. Household-level volatility in the consumption of nondurable goods has increased by at least a quarter since the 1970s, with much of the effect among households with lower incomes, such as minorities and those with lower education levels.

These two trends combine to make cash-flow management more challenging for low-income families. Households today are more likely to experience drops in income and increases in expenses. Emergency savings can provide liquidity to bridge these fluctuations, but low-income households have limited emergency savings available.

Measuring Emergency Savings

Lusardi (1998) notes that estimating precautionary savings is complex, requiring detailed information about current net wealth, lifetime income, spending, and the relative risk of an income shortfall. As a result of this complexity, studies of emergency savings use a wide variety of definitions of emergency funds. Some are based on a benchmark relative to income. For example, a benchmark of three months of income would suggest that someone who earns $36,000 per year should have an emergency fund of at least $9,000. Other approaches might be based on a portion of current consumption, such as three months’ rent or housing payments.

Often, studies define emergency funds based on how they are stored; cash and savings accounts that are accessible in short order are considered “emergency liquid funds” (Bhargava and Lown 2006). Of course, even equities and personal property can often be liquidated in a few days, potentially resulting in a larger range of assets that could be included. Other studies rely on subjective assessments of emergency funds, rather than labeling financial accounts. For example, Babiarz and Robb (2014) use a survey question: “Have you set aside emergency or rainy day funds that would cover your expenses for 3 months, in case of sickness, job loss, economic downturn, or other emergencies?” This approach has the advantage of incorporating the context of the family given their stage in the life course, as well as geographic cost of living differences, but becomes more challenging to quantify in terms of savings levels.

Finally, some studies ask people if they can access a fixed dollar amount, such as $500 or $2,000, within a set time period (Mills and Amick 2010). In this vein, Lusardi, Schneider, and Tufano (2011) define liquidity as “coping capacity” and link it to the family’s ability to come up with funds from any source in short order. Both, assets owned by the household and the household’s perceived ability to access credit or tap into resources provided by family or other networks may be included. The amount of funds and the number of days required to acquire funds both seem likely to be important. Smaller amounts could more likely be accessed via the most informal and liquid means, often in a few days. Larger amounts might require working with financial institutions or liquidating assets, taking a few weeks. Both may be of interest for practice, research, and policy, but these measures are likely to be distinct constructs depending on the amounts and time frames involved.

Barriers to Emergency Savings

While economic theory would suggest that households should save based on expectations regarding future income and expenses, numerous studies show many people lack liquid savings, especially low- and moderate-income households (Gjertson, this volume). Without easy access to liquid savings, people turn to other alternatives, including short-term credit, friends and family, and potentially even public subsidy programs. Why do people fail to save even small amounts for contingencies? The literature suggests a range of reasons, from program rules to a lack of knowledge. Ultimately, a lack of resources is a major factor, along with behavioral biases such as procrastination.

Some researchers suggest that the existence of public assistance might reduce savings motivations (Carter and Barrett 2006). This discussion focuses on whether welfare and unemployment policies might inhibit savings, since people facing an income loss could claim unemployment benefits rather than having to rely on precautionary savings (Lise 2013). Unemployment insurance does not cover unexpected expenses in the absence of a loss of employment, however, and access to unemployment insurance is not universal (Ben-Shalom, Moffitt, and Scholz 2011). Thus, the existence of unemployment coverage is not sufficient to explain the lack of emergency savings.

Another potential barrier to saving is that public assistance programs may include asset tests, which could preclude people who have emergency savings from accessing benefits. For example, Supplemental Social Security (SSI) benefits restrict a single person to a savings balance below $2,000 and a married couple to a balance below $3,000. In some states, Supplemental Nutrition Assistance Program (SNAP) and Temporary Assistance for Needy Families (TANF) have asset tests, typically around $3,000. However, the connection between asset tests and savings is unclear. Hurst and Ziliak (2006) find no connection between asset limits and low savings rates among low-income households, but O’Brien (2008) suggests that even the perception that savings may make a household potentially ineligible for welfare supports may discourage some savings. It seems asset tests are worthy of scrutiny, but they are not the only barrier to emergency savings.

Emergency savings can be stored in a variety of forms, including cash, but the prototypical form of savings is a demand deposit savings account at a financial institution. Since about one in ten households lacks a bank account, and an even higher share of low-income people lack savings or checking accounts, not being banked could be one barrier to saving for an emergency (Rhine and Greene 2013). An explicit link between the use of mainstream banking and the accumulation of emergency savings is unlikely, however, since even the unbanked can use alternative mechanisms to store funds. Nevertheless, the formality and safety of these savings accounts may be associated with accumulating emergency savings. However, there are not many savings products that are well designed for low-balance emergency savings. Even among banked households, fees for maintaining small-balance accounts might discourage using a savings account as a store of liquidity. Although inflation has not been a c...

Table of contents

• Cover
• Title
• 1   Paying for the Unexpected: Making the Case for a New Generation of Strategies to Boost Emergency Savings, Affording Contingencies, and Liquid Resources for Low-Income Families
• 2   Liquid Savings Patterns and Credit Usage among the Poor
• 3   Upside Down: The Failure of Federal Tax Policies to Support Emergency Savings
• 4   Save at Home: Building Emergency Savings One Mortgage Payment at a Time
• 5   The SaveUSA Coalition: Using Behavioral Economics to Build Unrestricted Savings at Tax Time
• 6   Refund to Savings: Creating Contingency Savings at Tax Time
• 7   Enhancing Financial Capability: TANF Bank Accounts
• 8   Building Emergency Savings through “Impulse Saving”
• 9   Prosperity SmartSave Card: An Incentivized Emergency Savings Strategy
• 10   Accelerating Savings among Low-Income Households
• 11   Start2Save: Helping Working Families Meet Unexpected Expenses and Opportunities
• 12   Incorporating Savings into the Debt Management Plan
• 13   Who Said Pigs Can’t Fly? A Learner-Centered Approach to Emergency Savings
• 14   Epilogue: Emergency Savings as a Central Component of Family Financial Security
• Notes on Contributors
• Index