Colin Long CFP®, Director KZN, Consolidated Financial Planning

Financial Planners spend hours developing and formulating financial plans for clients. All the exciting planning like clarifying their goals and developing a strategy to help them achieve those goals has been accomplished. We show them the volatility of their investment strategy, the asset allocation and the selected fund managers. More time is spent devising tax-effective structures for investment, retirement and estate planning … only to conclude this planning with recommendations on the importance of having an emergency fund. This part of the plan is about as boring as having lunch with my aunt Mildred. Let’s face it, there is nothing sexy or exciting about setting up the emergency fund yet it’s one of the most important parts of the financial plan.

Why is it so important? Cliches abound: the only thing certain in life is change, life tends to throw us curve balls when we least expect it. The emergency fund is there to help take life’s little knocks on the chin as opposed to a left hook to the jaw.

How should the emergency fund be set up? What needs to be considered?

1. The first step is that the funds must be easily accessible, i.e. they should be available to you almost immediately without incurring costs such as exit penalties. A money market fund is thus one of the most appropriate investments to use, not only because the funds are available on demand, but also because the interest earned is generally higher than the interest you would earn on a savings account or cheque account.
2. The second step is in deciding on how much money should be invested in this fund. A good rule of thumb is that it should be equivalent to three to six months of your monthly living expenses.
3. Tax needs to be considered. If your monthly living expenses are a R100 000 per month, according to point two mentioned above, you should have R300 000 to R600 000 in this fund. However, should this be invested in a money market fund with a 10% yield, you will have to pay tax on the portion of the interest that is not exempt. Thus other investments such as guaranteed preference shares may be more appropriate for the balance of the money.
4. Consider Costs vs Investment Yield. A money market unit trust may be more costly than a market trader account; however, the money market unit trust may offer a higher yield.

What are the consequences of not establishing an emergency fund?

If your financial plan was set up to be only tax-efficient, and investment vehicles such as retirement annuity and endowment structures were used with little or no consideration for liquidity, then you could find yourself in a situation where an unforeseen event occurs and you have little or no access to your funds. This could result in your exiting from some of these investments with considerable exit penalties or having to borrow money from the bank at high interest rates

What are some of the common investments that you can use to establish an emergency fund?

1. A savings account
2. A current or cheque account
3. Credit balances on your credit card
4. The equity in your home, but this is not recommended
5. Money market accounts offered by your bank
6. Money market unit trusts
7. 32 day call accounts
8. Fixed deposits
9. Guaranteed Preference shares