Emergency fund is something most of us would have heard about or read about somewhere. But have you wondered why it is so important?
I apologize for this macabre example, but nothing drives home the point like death does! Imagine a scenario where you have passed on. Hopefully you have planned ahead and have a good life insurance that will cover all liabilities and leave enough over for your family to live comfortably. But what will they do until the life insurance claim is approved and is available as hard cash? You can substitute dying with job loss or being laid low due to health issues. The question remains. What will you family live on when there is no income?
Why do we need an emergency fund?
As the name indicates, an emergency fund is to be used strictly for situations where your income stops. The reasons why you might not have income for the short term are many – job loss, health issues, variation in freelance income. Job loss is something we in India have not experienced in general over the past, but the possibility is ever increasing. Just look at the IT and Pharma industry in recent past and the 2008-09 economic crisis. Emergency fund is a type of insurance to guide us through this short term financial storm.
Imagine yourself going through this scenario without readily available funds. You would either have to sell off some asset or borrow to tide yourself through this moment of crisis. Both have big drawbacks. Selling off your carefully planned investments impacts your long term goal planning and the timing of sale might not be appropriate. But the most important aspect to both these options is liquidity – how soon can you convert your investments to usable cash? In some medical situations you might need money in the next couple of days, so how soon you can lay your hands on cash is extremely important
How much do we need?
Just like all other things in personal finance there is no one size fits all approach here too. The general rule of thumb is have a fund that covers at least 6 months of expenses. Expenses here includes anything that has to be paid for – rent, living expenses, insurance payments, loan repayments & education. Any discretionary expenses, like vacation, that you can postpone need not be planned for.
Determine the coverage required
- Do you have multiple sources of income? – Both spouses might be working or you might have some income sources that do not need your active participation. In these cases you are at less risk of losing all sources at the same point. So you can have only 3 months of expenses as your emergency fund. This will make sense if your family income is split equally between multiple unrelated sources.
- How many dependents do you have? – If you have your parents living with or dependent on you, you might want to budget extra due to increased health emergencies at old age. Maybe an additional 3 months of expenses.
- Risk of job loss – If you are in an industry where the risk of job loss or the duration of job loss is higher, you might want to be conservative and budget more. Maybe an additional 3 months.
- Already Retired? – I cannot comment on this from personal experience, but we are planning to have at least 3 years of expenses as an emergency fund when we move into our last year of working. This will be to tide us over any unforeseen movements in the economy that impact our investments
Determine the expense categories
Once you have determined how many months of expenses you need, list all your expenses in terms of categories.
Rent, Home loan EMI, Car EMI, Life insurance, Health insurance, Vehicle insurance, Education, Vacation, Living expenses, Essential clothing, discretionary shopping, home maintenance, home appliances, tax and so on.
Split these categories into 2 headers –
Critical expenses like rent, EMI, insurance education etc
Discretionary expenses like vacation, non-essential shopping etc.
This will now give you a good idea of the value of your emergency fund. Of course if you find yourself in an unfortunate situation, you will have to also look at ways to reduce your critical expenses for the short term.
How do we save for an emergency fund?
Well, if you are convinced that you need an emergency fund and also know how much you need, the next step is to save for it. Should emergency fund be prioritized over investment for long term goals? Should emergency funds be prioritized over discretionary expenses? Lots of questions and there is no right answer!
I firmly believe that emergency fund should be second only to expenses where you have no choice. If you can change your loan payments for the short term, emergency fund should take precedence. On a priority scale I personally rank emergency fund equal to life insurance payments.
My simple rule is to ask the question – Would you stop life insurance payments to spend on ________? Any expense item that gives an answer “NO” to this question should be treated on a lower priority to emergency fund.
If you are saving 20% of your income, you will reach a 6 month emergency fund in about 18 months. This is assuming a part of your expense is discretionary and does not need to be covered. This can be sped up a lot if you move your discretionary spending towards the fund.
I recommend using Recurring deposits as a way of automating this. One of the major benefits is to squirrel away income into the fund before you get an opportunity to use it.
Where do we invest it?
Emergency fund is an insurance. So treat it like one. The important aspects are value protection and liquidity. Any option that can be converted into usable cash within 1 day and protects it against inflation is suitable.
We have multiple option that meet the liquidity criteria but run into a problem when we consider inflation protection in India. All investment options except equity, do not protect us against inflation when we consider after-tax returns. This is not just consider CPI inflation but also education and health care.
Unfortunately, equity does not give us the liquidity we need. Another problem with equity is the inherent volatility. We can never time the market. It could happen that the market is at a low when you need the money. This means you have to sell more to get the same value.
Debt instruments like PPF & NSC have similar issues with liquidity. The only options left are FDs and Debt/Arbitrage based mutual funds.
After the fund is accumulated, we should split it between FDs and MFs. FDs since they are more liquid and are protected against market forces like interest rates. Debt MFs because on a longer term they give better inflation protection than FDs. This is because their historical returns are closer to inflation and the returns are treated as capital gains if we sell after 3 years.
- Identify your risk of losing income stream(s) – This will let you know how many months of expenses you need to cover
- Identify your critical expenses – This will let you how much is necessary every month to cover expenses
- Decide your priority list – Where does emergency fund sit within your monthly cash flow. Try to automate it using recurring deposit method
- Saving it – Invest it in FD and Debt/Arbitrage MFs. This will ensure liquidity
- Use it only for true emergencies. That unplanned vacation to Europe is not an emergency! You can travel after you have saved for it.
- Relook at 1 & 2 every year to determine if the fund is adedquate.
The FS family is fortunate to have 2 independent low risk incomes and no dependents. We have still chosen to be conservative and have a fund that will cover expenses for at least 6 months including some discretionary expenses.
I believe that it is better to be conservative than aggressive while estimating the fund. Yes, investing another INR50,000 in equity can net you 5Lakh over 30 years more than emergency fund. But at the end of the day an emergency fund is an insurance. Any number that lets you sleep peacefully in the night is the correct number.
Do you believe that an emergency fund is absolutely essential? Do you have one or are saving for one? Share your thoughts. After all, we are all here to learn from each other.