Emergency Fund is all about Planning for Uncertainty. While liquidity and easy access is the most important requirement, the biggest drawback of holding funds in liquid form is low returns to no Real Returns. Hence Balancing the optimization of returns and maintaining easy access to an emergency fund is critical.
Besides the big question is: How much Emergency Funds should one hold?
While there is no one right answer and it depends on ones unique requirements, factors that influence are stage of life, earnings, dependents, commitments etc. The usual threshold is for one to save 3-9 months of the expenses as emergency Funds including for the investments too. This is because one may have ongoing investments that one may not want to lapse or forgo the benefits of some investments because one is not able to pay premiums or instalments in time.
Now, let us break this down further to see what could be the ideal number of months holding as Emergency Funds considering the various factors listed above:
• Three months: Where you are an unmarried / single or a married couple with no kids or school going kids or other dependents, or where one has their parents with whom you stay, i.e., there is no commitment towards expenses like rent, three months of funds in emergency savings would be a good amount to sail through any rough times.
• Six months: For couples who both may be working – with schooling kids and any mortgage, six months of savings should provide enough for the family to get through a job loss of any of them or to meet medical emergency, or any another unplanned incidence having monetary implication.
• Nine months: Where you are the only bread earner in the family, or you have irregular income (like from business, freelancing, part time etc), having in emergency fund – nine months of expenses will be of great help to sail through when one is between jobs or in case of any emergency.
Now that we have an understanding of how much to stash as emergency Funds, let us try to understand with an example as to how one can structure the emergency fund to achieve both the objectives of liquidity and returns:
1. Tiered Approach to Emergency Funds
Divide your emergency fund into three layers based on the urgency of access and risk tolerance:
Layer 1: Immediate Liquidity (30%-40%)
This portion should be instantly accessible for urgent needs like medical expenses or sudden emergencies. Prioritize safety of capital and liquidity over returns.
• Options:
o Savings Bank Account: Ensure you have a high-interest savings account wherever possible otherwise typically saving bank account offer 3.5%-4% returns. While a few bank may offer higher rates of 4 – 7% and come with minimum / higher balance requirements or deposits attached to the savings accounts.
o Cash: Keep a small portion (e.g., 5%-10% of the fund) in physical cash at home for immediate use.
Layer 2: Short-Term Liquidity (40%-50%)
This layer can offer slightly better returns while maintaining quick access (1-3 days). Use these funds for moderate emergencies that aren’t as urgent.
• Options:
o Fixed Deposits (FDs) with Sweep-in Facility: These allow for partial withdrawal at need while offering 6%-7.5% returns. Also most banks offer higher rates for senior citizens.
o Liquid Mutual Funds: These invest in money market instruments and offer 6%-7% returns with redemption within 24 hours. Besides investing in Mutual Funds has an added advantage as compared to Fixed Deposits as gains are taxed only at redemption unlike in FDs where the TDS (if applicable is deducted quarterly).
o Recurring Deposits (RDs): Useful for building this layer systematically while earning 5%-8% interest depending on the tenure and the bank. Also most banks offer higher rates for senior citizens.
Layer 3: Higher Returns for Non-Urgent Needs (20%-30%)
This portion is for emergencies where you have a few days to access funds. The goal here is to beat inflation while ensuring relative safety.
• Options:
o Ultra-Short Duration Funds: Suitable for a horizon of 3-12 months, offering 5%-7% returns.
o Post Office Time Deposits: Secure and comparable to FDs, offering 6.9%-7.5% returns depending on tenure. The current interest rate on Post Office Time Deposits in India are 6.9% for a 1-year deposit, 7.0% for a 2-year deposit, 7.1% for a 3-year deposit, and 7.5% for a 5-year deposit; all interest rates are compounded quarterly.
o Gold ETFs: For those comfortable with some volatility, and also seeking flexibility and liquidity, Gold ETFs can offer as an option as they are freely traded and one can exit as desired without any lock-in period. Gains on sale of Gold ETFs are subject to capital gains tax as per their holding period.
Additional Tips
1. Automate Contributions: Set up automatic transfers to build each layer consistently.
2. Review Periodically: Adjust allocations based on changes in income, expenses, or market conditions.
3. Insurance is Key: Complement your emergency fund with adequate health and life insurance to reduce financial burdens during crises and support the family with immediate financial assistance in case of any untoward incidence.
4. Avoid Risky Assets: Stay away from high-risk options like equities or crypto for emergency funds, as these lack stability.
Let us consider an Example of Allocation for a ₹3,00,000 Emergency Fund:
• Layer 1 (Immediate Liquidity – ₹1,00,000):
o ₹80,000 in a high-interest savings account.
o ₹20,000 as cash at home.
• Layer 2 (Short-Term Liquidity – ₹1,20,000):
o ₹60,000 in an FD with a sweep-in facility.
o ₹60,000 in a liquid mutual fund.
• Layer 3 (Higher Returns – ₹80,000):
o ₹40,000 in ultra-short duration funds.
o ₹40,000 in Gold ETFs or Post Office Time Deposit.
This strategy ensures a balanced emergency fund that is readily available, largely inflation-protected, and optimized for returns.
Planning for emergency Fund is an important step in Financial planning, ensuring that you are not forced to liquidate your investments at an ill opportune time to meet your emergency needs.
