Why Emergency/Contingency Fund?
Mr. Smart works for a big Multi National Company in a senior position and is going for a private holiday with his family, he is also looking to replace his furniture with a newly imported model that he saw recently in a big shop.
Are these requirements of Mr. Smart that of an Emergency, certainly not. Then what is an emergency and can one plan for an emergency fund?
In this article we would try to understand what constitutes an emergency, how can we plan for creating an emergency fund, what parameters should be kept in mind while constructing an Emergency or Contingency fund?
What is an emergency?
An emergency can come anytime in one’s life.
Loss of job, economic downturn, medical emergency, accident, and any such event which could come untimely and impact the financial stability of a household is an emergency.
Though one can’t predict these events but can surely be prepared for such events. An investor has to keep some amount for such emergencies and contingencies to meet these requirements.
Important points to note while constructing an emergency fund –
The very basic idea of constructing an emergency fund is that it should be highly liquid and be readily available at the need of the hour.
Liquidity comes at a cost i.e. the returns in a readily liquid instrument will tend to be lower but while constructing the portfolio our priority is not getting a high return rather having the money readily available.
The emergency fund should be easily accessible.
For example, in the case of a fixed deposit, one can easily break them even online but certain banks do not allow breaking offline deposits done online, so one has to be aware of any such caveats.
Liquid funds are also a good option and allow access to the funds in 1 day as the redemption is credited in a T+1 day ( T = the day of redemption ) and some fund houses allow redemption of 50% to 90% instantaneously.
3. Risk and return
The primary objective of the contingency/emergency fund is to have a corpus that is readily available in case of any emergency not to primarily generate return out of that investment.
One should also be aware that the most liquid investment is cash but it yields around 3.5% to 4.5% in the current scenario so an investor should also look at getting a bit better return without compromising on liquidity and accessibility.
How much should an investor have in the Contingency Fund?
The quantum of the emergency fund depends on multiple factors but as a thumb rule a total income of 3 to 6 months should constitute the Emergency fund, for example, a person earning 25,000 per month should ideally have approximately 75,000 to 1,50,000 as an emergency fund.
A few important points to keep in mind here is that if a person has medical insurance then his liability towards any medical emergency reduces as the insurance will cover the major cost and the same is the case with car insurance will which help in case of any major damage or breakdown of the vehicle.
An investor with a good credit card limit also can use this towards any emergency and hence the need for emergency corpus reduces but since a credit card is a debt one has to pay the outstanding amount which can be paid from a part of the Contingency corpus.
An emergency fund can be built gradually wherein an investor can keep aside a certain amount every month or at a periodic interval for the goals.
The emergency corpus can also be kept in two buckets –
- Very Short Term – this can be kept in cash or fixed deposit. The idea here is to have a higher degree of liquidity and make the amount readily available.
- Short Term – this can be invested in the ultra short term or even arbitrage funds with a horizon of 3 to 6 months so that one can first use the very short term fund followed by a short term in case of such a situation.
Once the liquid funds are used then the aim should be able to again save the funds and appropriately allot them for future emergency needs.
The below table shows the expected returns, advantages, and disadvantages of the various instruments that can be used as Emergency Funds –
This is the safest mode of deployment of investment for emergency funds.
Since the money is lying as cash in the bank account it is at no risk but the returns are also very low. The funds are immediately available in case of an emergency.
Sweep in Accounts
This facility has been provided by banks wherein investors can keep a certain minimum threshold amount in the account and any money above that amount is transferred in fixed deposits automatically (in the multiple of 10,000.00.
When the money is required the deposits are automatically broken and it is paid to the investor. The returns are slightly higher than the savings account and it is also a safe option.
Provide investors with a higher return than savings or auto sweep facility account which could be in the range of 6 to 7% and are easy to operate and redeem in the case of emergency.
Few banks do not provide the option of liquidation online if the deposits are made offline and might require a visit to the branch which can be a limitation.
Are debt funds but with a very low average maturity hence very less (almost negligible interest rate or credit risk) and are highly liquid and can be redeemed with a payout of T + 1 days (T being the date of transaction) hence the money is credited in the account after one day of redemption.
The liquid funds can give returns in the range of 6 to 7% over a year time period. The average maturity of these funds is in the range of 0.12 to 0.20 years which is around 30 to 90days.
Ultra Short Term Funds
These funds can give higher returns in the range of 7 to 8% over a period of 1 to 3 years but they come with a small degree of risk as well.
Average maturity in such funds is in the range of 0.3 to 0.5 years (90 days to 180 days) hence is exposed to slightly higher risk as compared to Liquid funds.
The money post redemption is credited to the investor’s account in T+2 days.
Prudent investors need to have an emergency fund in place before they start investing.
An emergency fund instills confidence and stability in the household and prepares against any adverse situation.