Help a Reader: What to Do with Severance Package

Here's an email I recently received from a reader:

Neighbor knows I keep a close watch on personal finance and asked me a question.  Not sure how to answer it, so I thought I'd pose the situation to your readers and get their advice.

Background

• Guy is married, three children (elementary school and younger).  Wife is not employed outside the home.
• No debts except for mortgage. 401(k) and IRA's, but not much of an emergency cash fund or other investments.  Used most of his money to put a big down payment on his house a couple of years ago.
• Guy just got laid off from his job.  Generous severance package, can get health insurance through COBRA for next 18 months while he looks for a new job.

Options

He's torn about what to do with the severance package.  He's mulling three choices:

1.  Pay off his mortgage to reduce his cash flow needs.  Has an adjustable ARM which is due to reset upward in early 2009.  He worries he might have to relocate if he can't find a job around here, and he might not be able to sell his house without a loss.

2. Invest in an index fund.  He worries the fund will decline and he'll need to tap it for cash if the job search takes a while.

3. Invest it in a money market fund until he finds a job.  He worries his cash flow needs will be high - because he has the mortgage - and that the money won't last as long as he needs when the ARM resets.

So what should he do?

I responded with my thoughts, but what do you suggest for this guy?

Comments

[tom]

My suggestion:

1) Look for a new job... anywhere, but try to find one with a generous relocation package (if possible)
2) Refinance the house to fixed rate in case you cannot sell and are stuck
3) Put the cash in a high yield savings account during the job search drawing from it when needed
4) Wife works part-time if possible

I wish him the best!

FMF, what was your suggestion?

[Rod Ferguson]

Option #3 is the most prudent, IMHO.

[aaktx]

Agree with first poster's comments. Would stay away from market if issues of liquidity exist and time horizon is too short. Refinance now because I doubt rates are going down anytime soon. In a stessful situation as this I would save as much as possible to ride out this downturn and avoid any unnecessary expenses(vacations, mall trips, buy generic stuff, cheaper gifts)

[Hants]

It sounds like the severance amount is greater than his mortgage.

My thoughts:

RE #1: He has 6 months before this is critical, and sufficient funds to pay it off if necessary. Don't change anything right now.

RE #2: NOT recommended. It is imprudent to mismatch terms (stocks are 7+ years, need is less than one year).

RE #3: Best choice for now.

Overall, he or his wife should consider working part time to provide *some* cashflow. He should be aggressively looking for a job (even in a new location), or retraining for a new one.

At the end of the year, re-evaluate.

If his accumulated expenses (including mortgage payments) will cause his projected mortgage balance at the end of the year to exceed his severance balance, he should should be acting now.

[FMF]

Tom --

I went for the money market. It's maximum flexibility for an uncertain situation.

[Kevin]

I would keep it all in a money market or high yield savings until the situation is more stable - ie the neighbor finds a new job.

Definitely do not invest the money right now as there is too much uncertainty in the short-term and he may need the money sooner than later.

Good luck.

[MattC]

I agree with #3 except I would refinance to a fixed rate. Keep as much cash as possible until a new job is found, then pay down the mortgage.

[Jim]

I'd take option #3 for sure. Put the money in safe savings short term and go find a job. Finding a job should be #1 priority right now. In the meantime you have to hang on to your capital cause you might need it for living expenses. Once he finds a job he can figure out what to do with his mortgage.

Jim

[Chris Meirose]

1. High yield savings account(s) with severance $$$
2. Depending on the quality of insurance, CORBA can be more expensive than being self insured. Looking into private insurance policies and compare. I would set aside 12-18 months of the severance in a separate high yield account (I use multiple ING accounts myself).
3. I would have another account with the amount to cover the mortgage funded from the severance package. Depending on the size of the package it would give me the info needed to know A) how long I have to find a job and B) how long I have until I have to re-fi my home loan.
4. I wouldn't lock up your liquid cash in paying off the house. Yes it buys down your monthly cash outflow, but it kills your flexibility. If you are close enough to paying it off, your payments are already mostly principle I'm guessing, so you aren't paying a high penalty to keep the flexibility.
5. Reduce expenses. Live without cable for the next 9 months. Drop the second cell phone. Cut back eating out. Read FMF for more ideas.
6. Get hot on the job search. Don't sit and be comfortable because you have a severance. You are far better to negotiate a later starting date with your new job so you can have some time off then you are to wait to find that job.
7. Be open to moving, especially to places with lower costs of living!

Big Chris

[Chris Meirose]

#2 - I would set aside 12-18 months worth of insurance payments in this account. Sorry I wasn't clear.

[Jordan]

In option 3 you basically answer the one question by stating "he worries his cash flow needs will be high". He needs to preserve his capital while earning as much as he can on that. Therefore, he should do what many responders before me have said, put the money in a high yield savings account or money market to maximize the return while preserving capital and liquidity.

Regarding health insurance, look for alternatives to COBRA. He may be able to get health insurance directly from an insurance company that will cost less.

Regarding paying off the mortgage or refinancing, do not do anything right now. Because he does not have a job, chances are the mortgage will cost more since he does not have any verified income. Also, if he ends up getting a new job that relocates him he will be spending money on a refinance for no reason. The fact that the house may be worth less now then the mortgage is moot. Refinancing will not change the value of the house or the amount he owes. If he pays off the mortgage he will still need funds to live on. Will he have any leftover and if so, for how long? That would be the only factor that may change my opinion on the house but unless it leaves more than one year in reserves, I would still hold off.

[Tim]

100% agree with Jordan

[Dedicated]

You don't mention other debt. Yet, imply that the severence is enough to pay off the mortgage. Finally, there is no mention if severence would have balance above mortgage payoff.

For me, I would pay the mortgage off, if I was debt free. It would be fairly easy to live on unemployment for 6 months with no bills and a scale back - while the job search continued.

Folks tend to want to spend when going through a trama like this - money could disappear with fully knowing where, like eating out.

Plus, budgeting the unemployment will be so easy when there are no debts or worries. I don't even flirt with the other options. I like the secure path. And I know for a fact that if I had no mortgage, I could earn enough to carry us doing lower grade work in an emergency. And this guy has 6 months to get back in a higher position.

[NH Mom of 3]

With no debt other than the house, I'd plunk down the severance into a money market or high yield savings account and draw that down over time as needed. Wait on paying off the house or trying to refi (with no current employer), they are not urgent concerns. If the job market in your region is anything like mine, it may take a while to find that replacement job. There are hoops to go through for the unemployment checks, and that can be discouraging as well...especially for someone who has been used to being the breadwinner for a family of 5. Kick that job search into overdrive, network with anyone and everyone, and the sooner you find a new job...the more of the severance money you will have as "bonus" money -- to pay off the house, relocate, set up an emergency cash fund. I agree with an earlier post about looking at other health insurance options besides COBRA. Even a high deductible ($2500-3000) plan would be an option with the cash in the bank to cover that deductible. If he had set up a health flex spending account, he could still get reimbursed for out of pocket expenses. Just a thought. Best of luck to him!

[Laurie]

In some states, the state unemployment agency will partially subsidize COBRA payments for laid off folks. This may help ease the COBRA burden somewhat.

I agree with most that he should just put the severance in a high yield account and use for cash flow.