CASH is not king, so why should you maintain an emergency fund? And why are we debating this again? The subject of emergency funds has been discussed so often that it has lost all novelty and interest. Because an emergency fund is critically important, that’s why. The consequences of doing it wrong can be dire: not having an emergency fund, having too little in your fund, or keeping the fund in an incorrect instrument.
Here’s what you need to know about this key element of your portfolio, and how to make sure you’re properly prepared for anything that life throws at you.
• What constitutes an emergency?
According to the Google dictionary, an emergency is II a serious, unexpected, and often dangerous situation requiring immediate action”.
• Why is this definition relevant?
Well, it helps us clarify what is not an emergency. Paying taxes, an unplanned holiday, that special anniversary that slipped your mind … These might require action, but they’re not serious or dangerous, even if some husbands might try to plead otherwise! Life happens and you will be faced with real emergencies from time to time: medical procedures not fully covered by your medical aid, an unplanned overseas trip because of a family situation, losing your job, or as we saw during lockdown, receiving only a portion of your regular income. The last thing you want to worry about in any of these situations is money.
• Which instrument to use?
You wouldn’t dream of digging your house’s foundations using a teaspoon, or running the Comrades in a pair of stiletto heels. Likewise, you have to select the most appropriate investment instrument for the specific need you wish to meet in a portfolio.
Cash investments have never been the teacher’s pet, since it often is the pet when interest rates are high. This means that even though interest rates are not attractive right now, a money market account might still be an appropriate instrument for an emergency fund if it ticks all the boxes.
• Which boxes need to be ticked?
An emergency fund needs to be available immediately and the capital amount must earn interest, but the balance shouldn’t fluctuate wildly according to the movements of the market. Similarly, there should be no penalties when funds are withdrawn, and any withdrawal should not be detrimental in some other way.
The requirements of immediate availability and no withdrawal penalties speak for themselves. Earning interest is a more contentious issue: you don’t want to go for the highest possible interest rate on offer, since that might involve a notice period to withdraw, but it is good to earn some interest on your emergency fund. Don’t just leave it in a 0% interest account because you’re too busy to investigate other options. On the market question, markets are volatile – you don’t want to withdraw from an investment during a market downturn. Just imagine the consequences if your emergency fund had been linked to the market during March 2020 and you needed to make an urgent withdrawal! The final point about a withdrawal not being detrimental in some other way rules out using
a tax-free savings account for your emergency fund, since any withdrawal from such a fund cannot be replaced and will thus reduce your maximum lifetime contribution of RS00 000.
• How much is enough?
This has also been the subject of heated debate among financial planners. As a general rule, your emergency fund should amount to three- to six months’ worth of basic living expenses, but the Covid-19 pandemic has shown us just how rapidly an emergency fund can be depleted when your income is taken off the table. My advice is to always err on the side of caution, and rather aim towards the “six months” side of the scale instead of the “three months” side.
Having said that, it’s equally important not to keep funds in your emergency fund that should be out there in the world, working to bring capital growth to your portfolio. Discuss the appropriate amount with your financial planner to ensure that your portfolio doesn’t have an overweight allocation in cash.
In conclusion, an emergency fund is a non-negotiable part of your financial plan.
Don’t stress about the low interest earned on this portion of your portfolio – high earnings are not part of its job description. Being available when you need it and not running out too soon – that’s what you need from an emergency fund.
So, love your emergency fund and love the peace of mind it will bring you even more!
Hester van der Merwe is a Certified Financial Planner at Ultima Financial Planners and the Financial Planner of the Year 2020.