Many of us must have heard about the story “the Ants and the Grasshopper” where the ants strive to create a stock of food during the summer season to utilize it for the rainy days. On the other hand, the grasshopper hardly bothered about hoarding some food for himself and made fun of ants for not enjoying the present and working hard to preserve food for the rainy days. But eventually, when the season changed and the rains poured in, the ants were comfortable as they planned judiciously for bad weather but the grasshopper was unable to sustain as he could not find any food during the rainy season.
Similarly, we never know when life throws a financial surprise on us. Life is unpredictable and unfortunately we all don’t have a magic wand to set up things as per our own choices and requirements. We never know what will happen next. So how to deal with an uninvited emergency in life which will have an impact on our financial equilibrium without a magic wand? The only way out is to create your own magic wand which in a practical sense implies adequate planning for the creation of an “EMERGENCY FUND”.
What is an Emergency Fund?
There are multiple situations in life which will pop up without a disclaimer like a sudden lay off in your organization, a medical emergency in the family in the form of a chronic illness or an accident resulting in disability or hospitalization, loss in business, some unexpected tax liabilities,change in economic scenarios like we all recently experienced- Demonetisation
, etc. Such uncalled, unexpected and unplanned situations which will have a financial impact on your planned or routine expenses calls for a creation of an Emergency Fund.
“Emergency fund is the periodic saving in the form of a reserve kept aside to help you financially during an uninvited financial exigency. It is a pool of money which will help you to combat the sudden, unanticipated and unknown financial situations to cover the financial shortfall till the time you attain financial normalcy.”
How much to set aside as an Emergency Fund?
The thumb rule says an individual must stash amount which is at least equal to sustain 3 to 6 months household expenses of an individual. This could be easily be calculated by assessing the monthly expense and then multiplying it by 3 or 6 or reviewing the trend of the past 3 to 6 months household expenses. But simply following the thumb rule may not be valid for everyone. Higher the financial instability in one’s life requires a higher corpus for creation of an emergency fund and vice versa. The amount of emergency fund varies from an individual to individual based on a number of factors.
Number of Earning members:
The amount of emergency or contingency fund will vary either you are a single earning member or a double income household. In case you are the only earning member in your family, you need a larger fund for contingencies as you won’t have any other source of income pouring in to manage the financial surprises as compared to double income households. This does not imply that households with more than one earning source do not require the emergency fund. But still the situation can be handled with another source of income in case one member loses a job or face losses in business. The worse scenario can be all the earning members losing job together.
Number of Dependants:
The more the number of dependant, the higher should be the contribution towards the emergency fund. For example, in case you have a family set up where you have a dependant spouse, kids and parents, you need to have a larger emergency fund kitty as compared to a household who have earning spouse and only one dependent kid.
Stability of Occupation:
to understand this factor let us take few examples like a person employed with government organization will not be laid off from the work normally without attaining a retirement age.On the other hand a person employed with a private organization may have to lose job in case of sudden shut down of the company due to financial loss, or in case of any merger or acquisitions, etc. So, the individual working with government organization may create an emergency fund basis 3 months household expenses which may not be sufficient for a person with an unstable job. Similarly, a person on contractual based job needs to be more sensitive towards creating a larger amount of emergency fund as compared to a person with a permanent job.Likewise, a person employed a small business houses are more prone to losing a job as compared to a person employed with an established big organization thereby the amount of emergency fund might vary considering the probability of income loss.
It is important to take into account fixed, unavoidable expenses like EMI’s, utility bills, insurance premiums, kid’s education fees, etc. for determining the quantum of the emergency fund. Households paying large EMI’s are impacted significantly when the income stops or reduces or diverted towards urgent financial requirements.The emergency fund will vary as per the regular outflow of unavoidable expenses.
Alternative financial arrangements like a health insurance policy, personal accident insurance policy, critical illness insurance policy will take care of the financial amount required in case of a medical emergency or hospitalization. Individual equipped with such protection plans may have a lesser amount kept aside as an emergency fund as compared to an individual with no health insurance policy or with a lesser health cover (which is not sufficient to take care of current medical health care costs). Also, people with larger debit/credit card limits may able to manage the temporary financial instability as compared to people without such plastic money.
Where to park your Emergency Fund?
After you have analysed the quantum of your emergency fund, it is time to periodically save the amount and park it in a safe way. Some people like to stock the emergency fund in the form of cash at home while others don’t want to keep their money idle waiting for an emergency to utilize the fund. There are various ways and instruments where one can park the emergency fund.However, it is important not to overlook these factors:
Liquidity: The word emergency signifies an urgency. Therefore the money should be parked in such an instrument where it could be easily converted into a usable form to combat the emergency situation.
Accessibility: The money should be easily accessible at short notice like in a savings account.
Low risk: The objective of investing the emergency fund money should be for safety and not to expect big, high or volatile returns.Safety is more important than returns in case of an emergency fund.
There can be instruments like savings account, fixed and recurring deposits,short term debt fund,etc.which may earn a return ranging from 4% to 8% depending upon the type of instrument.It is advisable to invest major portion of your fund into short term debt funds, ultra-short term debt funds and liquid funds which may account 60 to 70 % of the fund amount.Remaining amount may be invested in longer term debt funds or strategic bonds offering good returns.A very small proportion like 5% to 10% might be invested in equity to give a compensating return to the overall emergency fund growth. Don’t invest a higher proportion of money into aggressive instruments like equities.
Key Take Aways:
It is prudent to have a Plan B when Plan A fails. An emergency fund can help you to overcome those phases till the time you attain financial normalcy. Saving for a rainy day makes a good financial decision and forms an essential foundation of an audacious financial planning.Utilize your emergency fund wisely. Remember, the emergency fund is not accumulated for personal wants or desires like for sponsoring a vacation or buying a new car. Creating an emergency fund will develop a discipline of regular saving habit and enable you to save a substantial amount for the unanticipated financial setbacks. Even if you don’t have a big fund to handle everything, an emergency fund will reduce your dependence on borrowing funds from friends or relatives or from a creditor at high interest rates. Eliminate unnecessary expenses and start saving with a smaller amount and step by step increase your savings towards the emergency fund by reviewing it timely as per changed lifestyle and income scenario. Live your life with a peace of mind by having a back up plan.
The author, Shikha Verma, is a Seasoned Insurance Professional at ComparePolicy.