We all experience our share of money-related hiccups from time to time. Our cars break down. Our garage doors stop working. Our bills come in higher than expected when holiday spending comes to a head. But there's a difference between a dose of financial upheaval and a full-fledged episode of income shock. And the latter affects almost the entire U.S. population at one point in time or another.
Prepare for the blow
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We all like to think we're immune to periods of major financial unrest, but a study by The New School for Social Research found that 96% of Americans inevitably experience four or more income shocks in their lifetime. The report defines an income shock as a 10% or greater decline in pay, typically resulting from factors such as illness or job loss.
Of course, it's easier to recover from a lone income shock than a series of financial disasters. Imagine you're used to earning $60,000 annually, but you get laid off and wind up only bringing in $50,000 during a given year. You might feel the impact for several years, but you'll recover eventually. On the other hand, if you experience, say, five income shocks at various points during your career, it'll be much harder to pick up the pieces.
In fact, the aforementioned study uncovered a huge link between health-related financial problems and retirement savings deficits. Specifically, it found that less-than-stellar health will generally reduce one's retirement savings by up to $34,500, while poor health will reduce one's nest egg by up to $86,300, on average. Yikes.
But it's not just health problems that tend to destroy our finances. The study also found that 61% of workers wound up going at least one year during their careers with no income. And 25% experienced four such episodes by age 70. For the latter group, that translates into a loss of nearly $25,000 in retirement savings, on average.
Of course, despite our best efforts, we can't necessarily prevent income shocks from hitting us where it hurts. Sure, we can all schedule yearly physicals and take our medication like we're supposed to, but sometimes, even healthy people get hurt or sick. Similarly, sometimes even star employees wind up getting downsized through no fault of their own. What we can do, however, is take steps to build our own personal safety nets so that if an income shock strikes, we'll have an easier time bearing that blow.
Build that emergency fund
If there's one lesson to be learned from all of this, it's that regardless of how healthy you might be or how much you earn, you need emergency savings to protect yourself from the unknown. As a general rule, the typical worker needs enough money in an emergency fund to cover three to six months' worth of living expenses. If you don't have any dependents and you tend to live well below you means, you could probably stick to the lower end of that spectrum. But if you own a home, are liable for a car payment, and have children (in other words, expenses you can't get out of), then you'd be wise to aim for the top of that range, if not higher.
Of course, the fact that so many people tend to experience income shocks underscores the importance of not only having emergency savings, but also replenishing those funds as needed. Though you shouldn't hesitate to dip into your savings to soften the blow of an income shock, once you're back on your feet, it's critical to start rebuilding that safety net.
Finally, if you're faced with an income shock -- whether due to illness, job loss, or another factor -- try to resist the urge to tap your retirement savings. Many people regard their IRAs or 401(k)s as an emergency fund of sorts, but in reality, your emergency and retirement savings should be two totally separate things. Any time you take an early withdrawal from a retirement account, you'll not only risk being penalized, but you'll reduce the amount of income available to you during your senior years. And that's a move you may never recover from.
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