Skip to main content

Imagine driving a car that had no shock absorbers. The constant jarring from all the potholes and bumps along the way might force many of us to pull over and stop before we arrived at our final destination.

That’s the premise of a new working paper that suggests one reason many people will fall short of their retirement funding goals is because we don’t have appropriate emergency funds set aside for all of life’s little bumps in the road. As a result, we raid our retirement savings.

The authors suggest testing the idea of employer-sponsored emergency funds. By making it easier to build up emergency funds, households will be better equipped to absorb the financial shocks along life’s way.

Currently, for every dollar contributed to employer-sponsored retirement savings plans in the United States, recent research found that between 30 per cent to 40 per cent can be taken out before retirement. It’s not hard to envision a scenario in which a recession would not only lead to job loss, but also to withdrawing money from retirement savings at market lows. A double whammy.

“If you take the money out of the account before retirement, it’s not going to be there when you need it in retirement,” Brigitte Madrian, professor and dean at the Brigham Young University Marriott School of Business in Provo, Utah, and one of the authors of the paper, said in an interview,

Dr. Madrian has been tackling how to get people to save more for retirement for two decades. Early withdrawals were a common observation. “That would be okay if people were putting in more than they need for retirement into those accounts in the first place, but there’s a lot of evidence suggesting people aren’t saving enough for retirement.”

By having a dedicated emergency fund, people may be much less likely to raid their retirement savings. This is in part prescribed by research into mental accounting, which is the phenomenon in which we treat money differently based on various factors, such as the labels we might assign to different sources of funds.

But setting up a labelling partition has deeper consequences than first meets the eye. Not only would we be less likely to raid our retirement funds for emergency expenses, we would reduce our spending on emergencies, too.

As an example, suppose you didn’t have an emergency fund because you were relying on your retirement savings to do double duty as your rainy-day funding source if needed. And let’s say you have $100,000 in your retirement account. Then one day your refrigerator breaks down.

Dr. Madrian explained that it would be really easy to think “Oh! I could get a refrigerator to replace what I have for $1,000. Or, since I have $100,000 in this account, I could buy a really, really fancy refrigerator for $2,000.” Taken further, the lack of an explicit rainy day fund could turn a scenario such as this into one that kick-starts a $20,000 kitchen renovation.

If you’re familiar with the potato chip commercial where once you open the bag, you can’t eat just one chip and often end up eating the whole bag, it’s the same idea, Dr. Madrian says. By setting up that separate account for emergencies, you’re basically giving yourself a smaller bag of potato chips to play with.

Instituting employer-sponsored rainy-day savings accounts would undoubtedly raise the concern about substitution effects. In other words, with some money now going to an emergency fund, would that not crowd out retirement contributions and lead to lower retirement funds as well? Dr. Madrian believes the question really is about competing substitutions.

Right now, people are accessing retirement funds as a substitute for not having emergency funds. This is leading to sub-optimal outcomes of lowered retirement funding as well as possibly frivolous emergency spending.

Incorporating a rainy-day fund would offer a solution with its own substitution effect (more emergency funds versus less retirement contributions), but if having the dedicated fund leads to less emergency-fund spending, then this would be the superior choice. There could be other potential benefits such as stress reduction, which has been linked to higher productivity by employees.

The paper makes an active call for employers to test their hypotheses and for regulators and lawmakers to support them. Hopefully we’ll see that testing soon, but in the meantime, Dr. Madrian shares some advice.

“Mental accounting is something that really does help people do a better job of managing their money and having a separate account set aside specifically for rainy days or emergencies is something that most people would benefit from. You should go ahead and set that up for yourself with an automatic transfer when you get paid.”

Only saving for retirement and not paying attention to all the other aspects of our financial life is like buying a car and only ever worrying about putting gas in the tank, with little regard for regular maintenance such as checking the suspension. Having an emergency fund will help us deal with the bumps along the way to retirement.

Preet Banerjee is a management consultant to the financial services industry and founder of

Go Deeper

Build your knowledge

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe