Contingency Fund - Smoothen life's financial bumps
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Hi!
Last week I talked about creating an emergency fund, and how the priority is to access the money quickly and reliably. The purpose of the emergency fund is to provide enough liquid cash for any emergency event quickly, not to cover the complete expense over the full duration. To cover for any loss of income / temporary increase in expenses, we need to keep a contingency fund.
This is not another emergency fund
A contingency is usually a provision for a possible event or circumstance in the future. So a contingency fund is money set aside to meet any needs that arise due to these events or circumstances, such as:
Job loss due to a recession or a medical issue
For double income households, if one spouse chooses / is forced to leave their job.
A natural calamity which causes damage to one’s house, property, or source of income.
An extreme event like death or fatal accident to a family member.
The contingency fund should be able to meet basic expenses for the duration of the event, such as rent, groceries, utility bills, and maintenance of vehicles.
The main driver to create a contingency fund is to avoid going into debt when going through these phases. One also would not be forced to sell long term assets like equity in unfavorable times to fund the loss of income / rise in expenses.
But we have insurance for this stuff right?
We do have insurance to cover the major events like death, health issues, home or vehicle damage. This would cover most, if not all of any unexpected loss of income or rise in expenses. But insurance is not fungible - one can’t use the money for any other use which is not covered by the policy. We also can’t have insurance for everything, such as one partner being forced to leave their job, or if the employer has temporary cash-flow problems and can’t pay that month’s salary on time.
To tide over issues like these, it’s prudent to keep some money aside.
How much to keep aside
Like we discussed in a similar section on emergency fund, we don’t usually have multiple contingencies together. We can get by with saving enough for one large contingency.
A general recommendation is to keep aside enough for six months of current monthly basic expenses. Once that is kept aside, one can slowly build it up to one year worth of monthly basic expenses.
This allows for some leeway in case of a recession, where the job hunt might take a while. In case one partner needs to leave their job, then six months might help restructure some expenses to compensate for the loss of income.
Since the contingency fund number depends on current expenses, one needs to revisit this number after every major life event like marriage, or birth of a child.
Where to keep this fund
The priority for this fund is availability and capital preservation. Unlike the emergency fund, we can get by without accessing this money for a few days. If there’s any delay, we can use our credit card / emergency fund to tide us over that period and then use the contingency fund.
Here are some avenues one can use:
Savings account
A savings account is available and provides capital preservation in absolute terms. But relative to inflation, we’re guaranteed to lose out because the interest is always lower than inflation. If we want the contingency fund to be in the savings account, we need to add money each year to compensate for any loss due to inflation.
A good idea is to split the money into multiple banks to avoid having our money frozen if the bank ends up in trouble.
Fixed deposit
Like a savings account, a fixed deposit is also highly available, but doesn’t provide capital preservation relative to inflation even with a higher interest rate. We will need to add money each year to keep up with inflation.
Another headache with fixed deposits is its taxation, where we need to report interest earned each year, irrespective of needing it that year or not. That eats up any hope of catching up with inflation.
Short term debt funds
Short term debt funds like overnight funds, liquid funds, money market funds, Ultra Short Term funds are my preference. The funds are available after a few days (max 10 days), before which I can use my credit card as a buffer. They are riskier than a savings account / fixed deposit, but these funds usually hold bonds maturing in a few months. Interest rate fluctuations don’t impact these funds a lot, and they recover fairly quickly. Their return can come close inflation over a medium term considering indexation benefits after three years. Another advantage is taxation only on withdrawal.
PPF account after maturity
A mature PPF account can help with any sudden financial shocks. I have a PPF account for my retirement, which I can use for any large amount required in the future. Mature PPF accounts allow for one withdrawal a year, which I can use to fund any long-term increased expenses.
My PPF account has not matured yet, so this option is something for the future.
Wrapping up
Contingencies can keep our finances from derailing over the long term, like an emergency fund does for the short term. Taking on debt in a tough time may compound issues at hand, and that should be the last resort. It’s best that we prepare ourselves financially to be able to handle tough situations, and hope that it doesn’t happen.
Until next time!
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