July is National Savings Month. Where ordinarily communication around it would focus on practicing healthy financial habits, COVID-19 has revealed just how financially unprepared many investors have been for rainy seasons such as this one.
“Rainy seasons are part of everyday life. To help cushion the blow against unplanned expenses, every investor should ensure a sufficient emergency fund. This is the cornerstone of a robust financial plan,” says Noluyolo Betela, client relationship manager at Allan Gray.
Below Betela discusses the top six factors to consider when preparing an emergency fund.
1. Building insurance for your long-term investment
“An emergency fund will provide you with access to money and prevent you from abandoning your long-term financial plans when emergencies threaten to compromise your financial health. Put another way, it is a form of personal insurance for your long-term investments,” says Betela.
Long-term investment products, including retirement annuities and tax-free investments, are designed to grow your capital over long periods. These products have several benefits and restrictions. You cannot usually access the funds in your retirement annuity before you reach retirement age and you lose out on the long-term benefits of tax-free investments when you make premature withdrawals. With long-term goals in mind, many investors pick underlying investments with higher equity exposure for these products. This is usually appropriate, as long time frames iron out the ups and downs of the market allowing investors to benefit from greater growth over time than lower-risk investments.
2. Think about liquidity
“Cashing in any of your long-term investments to get you through a crisis during a market downturn could mean selling at a low and even walking away with less money than you contributed. Having an emergency fund in place will help you to avoid this worst-case scenario,” says Betela.
She explains that emergency funds are ideally suited to investment vehicles that aim to preserve your capital over the short term.
“Your investment should also be easily accessible. Many products, such as fixed deposits and other notice accounts, may offer slightly higher interest rates than a traditional savings account, but prove impractical when you need to access the funds immediately. Consider parking your emergency fund in a low-risk investment, such as a money market fund, which aims to deliver higher returns than a bank deposit and can be accessed in a short space of time if disaster strikes,” says Betela.
3. Setting a target
Setting a target for your emergency fund should be shaped around your personal circumstances. Financial advisers generally recommend building an emergency reserve that is large enough to cover at least three to six months’ monthly expenses.
“You may want to consider saving even more. Amid the uncertainty of the global financial crisis of 2007-2008, many financial experts encouraged investors to increase their emergency savings to up to eight months’ monthly expenses.”
Your emergency fund should buy you enough time to manage and recover from a crisis.
4. Review your fund regularly
“Regularly re-evaluate your emergency fund alongside your broader financial plan to ensure that it remains sufficient for your needs,” says Betela. “You will need to take factors such as inflation and lifestyle creep into account to accommodate your changing circumstances, otherwise you may be left out of pocket.”
5. How not to spend your emergency fund
Betela warns that the money in your emergency fund should not be used to fund a holiday, treat your loved ones over the festive season, or supplement the deposit on a new home.
“If you need to tap into your emergency fund to make essential repairs to your home or vehicle, that would be appropriate, but it should not be used to fund medium- or long-term goals. In fact, when taking on debt for a home or a vehicle, you should aim to have an appropriate emergency fund in place before you make the purchase.”
6. Don’t delay getting started
Betela says many of us fail to get started because we have taken out comprehensive insurance to cover the most common emergencies. This can give us a false sense of security.
“While income protection and short-term insurance policies have an important role to play as part of a well-thought-out financial plan, an emergency fund is invaluable when an insurance claim is delayed or disputed, or when your emergency falls outside the scope of what you are covered for.”
If you have not started building your emergency fund, the best time to do so is right now.
“An independent financial adviser can help you stay the course. Evaluate your current expenses and explore ways to cut back until you reach your target. Every little bit counts,” concludes Betela.