An emergency fund will work only if it is adequate and the money is easily accessible
With all the focus on the need to maintain an emergency fund, most people now accept it as the first step in securing their financial situation. There is awareness of the importance of having a cushion to break any unexpected fall in income or an emergency. If it has to function as the safety net you intend it to be, then keep the following points in mind when saving, holding and using your emergency fund.
What’s in a name?
If you think that earmarking some existing savings for emergencies is all that it takes, then you are mistaken. The equity investments that you are building for your daughter’s education or the money in the fixed deposit that you plan to use for making the downpayment cannot be designated as your emergency fund. The money must be held in a way that is suitable for emergencies.
“Some savings should be kept in liquid form, which can be easily accessed in the time of an emergency. One should try and avoid dipping into long-term investments unless absolutely needed," said Jitendra Solanki, founder, JS Financial Advisors. One formula to follow could be to keep 25% of designated emergency funds in a savings account and the balance in short-term mutual funds, he added.
Assess the amount you would need to be able to tide over a fall or loss in income, and hold only that portion in liquid assets.
You have to remember that savings and emergency funds are different. “For the amount kept as emergency fund, return on investment is of less importance. Easy liquidity is the deciding factor here," said Melvin Joseph, a certified financial planner, and founder, Finvin Financial Planners.
Be clear about what you will use the money kept under the head of emergency fund for. The money is to use for meeting essential needs in the event of your income falling short. Therefore, you should define your needs carefully and don’t confuse these with wants.
“If your car breaks down, that is not an emergency. An emergency is a situation that has heavy financial implications, say, loss of job, accident or disability, or hospitalisation due to illness. Catering to an emergency should be the top priority while making a financial plan or creating a budget," said Amit Kukreja, founder, WealthBeing Advisors.
Dip in, but refill
You may be feeling good about setting up an emergency fund, as you should, especially when there is a need for money and this fund is readily available. While an emergency fund is there to be used as required, that is just the first step. You need to refill what you have drawn.
“The emergency fund helps you tide over a critical situation without affecting your normal life. After some amount is spent from the fund, it should be replenished soon by investing any surplus coming in the near future," said Joseph. This has to be done so that money is available, should you need it again.
“People who have paid for hospitalisation expenses and have used all the money slated for long-term investments during this time, should get back to starting investments from the scratch as soon as they are back on their feet," said Solanki.
You may even consider prioritising this over other important goals in allocating your savings. “Start topping up your emergency fund and give this process the utmost importance, taking over all your other investments for that time period," said Kukreja.
Recalculate and calibrate
Your emergency fund requirement will not be a static number. Every time there is a significant change in your expenses and financial obligations, due to a life event such as marriage or birth of a child, the amount that you need to hold for emergencies will also change accordingly. Other events also may require you to adjust the size of the fund, such as, a double-income family to have only one source of income or increased medical requirements.
“With time, our expenses go up and so does the need for a bigger emergency fund. One should have an emergency fund that will take care of expenses for 4-6 months, and this should be reviewed periodically," said Solanki.
The review of emergency funds should happen twice or at least once a year, suggest financial planners.
“One has to be a smart investor even when it comes to the emergency fund, so that it earns the maximum returns yet remains easily accessible," said Kukreja. One way to do this is to park emergency money in ultra short-term debt funds and fixed deposits for short periods, and in liquid funds. Doing so will serve the dual purpose of maximising returns in a short duration, and providing liquidity.
Keep reviewing your emergency fund requirements and adjust every time there is a big change in your financial situation.
For example, if you have just paid off a home loan, then it can significantly bring down emergency fund needs. On the other hand, if you have just taken a loan, it can then push up what you need to provide for. If the household has a second income and there is no significant change in expenses, you may decide to hold a lesser amount for emergencies.
Risk versus returns
Savings bank accounts and liquid and ultra short-term funds are investments that are ideal to hold emergency funds. However, the lower risk and ease of access also means that the money will be earning very low returns.
If your financial situation allows it, you could consider taking a little risk to earn better returns on this money.
If you have six months’ expenses accumulated for emergencies, then have three months’ requirement in the safest and most liquid investments and the funds for the next three months’ expenses can be put in better earning investments such as short-term bank fixed deposits and short-term funds.
“Also, money invested in ultra short-term debt funds for over three years gives you tax benefits," said Kukreja.
With these instruments, there may be a slight delay in accessing your funds, or there may be some volatility in the value of the investments. But the first tranche of funds provides the cushion of time that you will need to manage these risks and redeem the second tranche.
However, one must remember that the primary purpose of an emergency fund is not to earn returns. Therefore, consider a course of action that means aiming for higher returns only if you have the security of income and savings to take on that kind of risk for emergency money.
Creating an emergency fund is not a one time effort—to do and then forget. It is an ongoing process.
You have to periodically assess if the funds are adequate for your needs, and make allocations from your savings for any short falls or replenishment required. It is only then that your financial situation will actually benefit from the security that having an emergency fund is supposed to provide.