Optimal Savings Liquidation for Income Replacement in the Presence of Income Uncertainty

Abstract The decision to liquidate savings for debt repayment is an important one that most consumers face at some time. Traditional financial analysis of this liquidation decision merely compares the interest paid on the debt to the interest earned on the savings, resulting in an almost universal recommendation to liquidate. This paper proposes that savings valuation should include a financial asset that has not previously been explicitly valued: an income replacement option. Applying an option valuation framework to the savings liquidation decision dramatically reduces the number of situations where liquidation is a proper strategy, particularly as income volatility increases. © 2007 Academy of Financial Services. All rights reserved. Jel classifications: G20; G11 Keywords: Personal saving; Emergency fund; Financial advising 1. Introduction A recurring question in financial planning is whether current savings should be liquidated to pay off existing debt or whether the savings has more value as a reserve should difficult economic times arise.1 As early as 1933, Watkins made the argument that the accumulation of a reserve for potential future expenses during times of economic distress should be the foremost goal of savers. In most situations, the existing debt charges an interest rate higher than the rate earned in liquid savings accounts. Therefore, it is not surprising that many people, and some financial planners, see the liquidation of savings to pay off debt as a valuable financial tool. On the other hand, many people maintain large savings accounts despite existing debts, and many financial planners recommend such a strategy. Who has the better of this argument, and is there a logical framework to analyze the situation for different individuals? Traditional financial analysis of this problem seems to yield a simple answer. If the interest rate on the debt exceeds the interest rate earned on savings, the savings should be liquidated to pay off or reduce the debt. If the savings are not sufficient to pay off the debt entirely, no new savings should be added until the debt is fully paid. The opportunity cost of savings appears to be higher than the opportunity cost of paying off the debt. This traditional financial analysis provides the evidence used by the financial planners who would advise the client to pay off the debt. For many individuals and financial planners, this advice seems risky or just plain wrong. Perhaps they cannot quite explain why, but somehow it just seems dangerous to completely liquidate a savings account. What will there be to fall back on should something happen? To this group of individuals and planners, the accumulation and maintenance of an emergency fund is such an important signal about overall financial health that it can be used to categorize potential clients into target and nontarget groups, according to Joo and Grable (2006). Although the intuition driving the decision making of the individuals in the Joo and Grable study is sensible, sound financial decisions are not made based on intuition alone. This paper proposes a framework for analytically evaluating the savings maintenance or liquidation decision. 2. Literature review Greninger, Hampton, Kitt and Achacoso (1996), in a survey of financial planning practitioners and financial planning educators, find that the consensus estimate for the necessary size of an emergency fund is 2.5 to 3 months of living expenses. However, Chang and Huston (1995) find that only three in 10 households have enough money saved to last three or more months. Clearly, the accumulation and maintenance of an emergency fund is a relevant issue to a large number of individuals. The corollary question of whether accumulated savings should be used to repay existing debt should be of equal importance. To date, very little attention has been paid to this corollary, and none has been devoted to an analytical model of the savings liquidation decision. …