Tags: Wealth Management, Investment Lesson, Mutual Funds, Stock market, Budget, Finance, Investing, Personal Finance, Investment
Article Summary
• An important aspect of financial planning is risk management with contingency planning.
• Contingency planning helps meet emergency expenses such as those related to health, sudden job loss, besides financial cushion during transition periods like mid-career education or career gaps.
• Contingency planning also prevents liquidating long term investments, taking expensive loans, and disruptions to home budgets, in case of a financial setback.
• Contingency planning strategies involve having adequate insurance protection for life, health and major assets like home and car, along with an emergency fund to address uninsurable emergencies.
• The emergency fund should aim to cover three months’ worth of expenses. A larger fund may be required in cases of fickle job security or family members with medical conditions.
• Emergency fund money can be parked in liquid instruments like bank savings accounts or liquid mutual funds.
• Risk management and contingency planning strategies need to be part of an annual financial review and need revisions after major life milestones like the birth of a child.
Emergencies do not come with prior intimation. They can inflict serious long-term financial setbacks on individuals and families. Surprisingly, we are often financially unprepared for emergencies. While there are numerous discussions on the importance of financial management, especially savings and investments, the same cannot be said about risk management through contingency planning.
Why We Need Contingency Planning
Introduction to contingency planning
For major future goals like buying a home, children’s higher education, and retirement, the importance of smart financial management can hardly be overstated. However, the crucial first step in management of family finances is contingency planning. It helps meet expenses from emergencies such as those related to health and motor accidents besides sudden job loss and expenses during transitions like mid-career or continuing education.
Contingency planning also helps avoid some of the damaging effects of emergency expenses such as premature exit from long term investments, taking expensive loans and disruptions to home budgets and regular investments.
Contingency Planning Strategies
Contingency planning to contain the financial impact from emergencies can be done in two broad ways. First, identify emergencies that can be covered through financial protection from insurance coverage. Risk management for such emergencies involves paying annual premiums for insurance covers for risks to life, health, income (risk of disability), besides major assets like home and car. Appropriate levels of insurance protection can be achieved with the guidance of a qualified financial advisor.
Second aspect of contingency planning strategies involves contingency planning for events and situations not covered by insurance. That is the reason all qualified financial advisors recommend that every person’s risk management and contingency planning includes creation of an emergency fund.
What is an emergency fund?
This is typically a sum of money kept aside to meet emergency expenses such as medical emergencies not covered by health insurance besides others like a sudden job loss. As part of contingency planning strategies, a financial advisor will typically recommend creating an emergency fund or contingency fund equivalent to 3-6 months of expenses.
Why You Need Emergency Fund Planning
Any experienced financial advisor would stress on the importance on securing one’s finances from unforeseen circumstances. This needs to happen before getting started with any investments. Thus, contingency planning is the first step in any financial planning effort. Consequently, emergency fund planning becomes a key part of contingency planning strategies. Here are some major reasons why everyone needs an emergency fund.
Protects from uninsurable emergencies This includes exclusions in insurance plans or expenses excluded from insurance coverage. This includes certain categories of expenses during hospitalisation, excluded procedures such as those for dental treatment, partly or fully excluded expenses after car mishaps such as plastic or glass parts.
Securing long term investments With an emergency fund, you do not need premature exits from long term growth investments to generate cash to meet emergency expenses. Often, such premature exits, especially from growth investments like those in equities, happen at a loss during adverse market conditions. Besides, investors are also left with far less time to accumulate substantial amounts for major goals in the future.
Helps avoid expensive loans It is common for people to use their credit cards and take expensive personal loans to meet emergency expenses. Loan repayment obligations of such expensive loans not only burdens home budget also puts pressure on regular investment regimen for major financial goals.
Assists in sticking to a home budget An emergency fund enables a person to stick to a home budget despite an episode of high emergency expenses. This kind of contingency planning contributes greatly to risk management of personal finances
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Helps meet unplanned expenses Emergency funds can also be useful in meeting unplanned but not emergency expenses. For instance, expenses in family and social functions and home repairs. Of course, one needs to quickly replenish the emergency fund with its use.
Cushions impact during life conditions or events These include conditions for relatively low income in single income families. Emergency funds are also especially useful for those with low or fickle job security as they help a family tide over a job loss over a few months.
For households with members with anticipated health emergencies, emergency funds can be of great help in keeping finances on track. Finally, emergency funds also help during transitions to lower or no income periods like sabbaticals for mid-career or continuing education or setting up one’s own business.
Creating An Emergency Fund
For effective risk management and emergency fund planning, one needs to first anticipate emergencies or contingencies and then set aside an appropriate amount of emergency funds.
Anticipate contingencies This involves identifying the possible source of emergencies. This will determine the size of the emergency fund. Thus, in early work life, emergencies could be health expenses or job transitions. This emergency fund amount will be lower than those with fickle job security, impending career transitions and those with elders in the family with health conditions.
Gradually build an emergency fund One could start with a target for emergency fund size of 3 months of expenses. This can go up to 8-11 months or more, when you anticipate income emergencies like a job loss or career transitions.
The next step is to determine where the emergency fund should be parked. Here, it is important to remember that it is easy accessibility or high liquidity, which is of paramount importance, not returns. In case of a large sized emergency fund, the portion not likely to be required instantly can be parked in exceptionally low risk investments that also provide some returns.
This emergency fund money can be parked among bank savings accounts, bank short term fixed deposits (FD) besides liquid funds. When the size of emergency funds is large, one can add arbitrage and short term debt funds such as ultra short term debt funds and even arbitrage funds.
Regular efforts towards building an emergency fund through mutual funds is greatly aided by Systematic Investment Plans (SIP). While building an emergency fund, one can start with 6-10% of take home pay for this purpose in SIPs.
Reviewing and Updating Contingency Planning
Anticipated emergencies change with time. That is why prudent financial management of household finances should involve periodic reviews of contingency planning. This can be done annually along with performance review of investments. Typically, the amount of emergency funds and insurance coverage should undergo a major revision after major life milestones. They typically need to be increased after marriage, the birth of each child, old parents moving in, on diagnosis of a major chronic illness besides retirement. Finally, emergency funds need to be replenished once they have been partially or fully used.
To conclude, while contingencies may arise without warnings. However, with an able risk management system in place and appropriate contingency planning, you can have the answers to tough financial questions during emergencies.
FAQs
1. Insurance covers and emergency fund involve significant commitment of one’s pay. Will it not impact investment efforts?
Inadequate provisions for contingencies can inflict a three-fold financial damage to individual finances. First, emergency expenses typically disrupt home budgets. Second, premature exit from investments to raise money and even expensive loans impact progress to major financial goals. Third, in case of emergencies disabilities after accidents there are continuing rehabilitation expenses and disruption in income earning during this period. Thus, it is better to be safe with adequate contingency planning rather than be sorry.
2. What are most rewarding investments for emergency funds?
The key for investments for emergency funds is easy liquidity, not returns. Therefore, it is imperative to have just the right amount of emergency funds. This can be done with contingency planning and regularly reviewing the requirements.
In case of comparatively large sized emergency fund, after leaving amounts that might be immediately required in bank savings accounts and short term fixed deposits (FD), one can invest in liquid, ultra short term debt and arbitrage funds for some returns.
Disclaimer:
The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. All complaints regarding Mutual Fund can be directed towards visit www.scores.gov.in (SEBI SCORES portal). Readers are requested to make informed investment decisions and consult Chaitanya Financial Consultants – 9000628943 / mfd.mmr@gmail.com to determine the financial implications with respect to investing in Mutual Funds.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
