3. RAINY DAY FUND
One question that arises quite often in the financial planning process is “What are you going to do in case of emergency?” More often than not it is met with a blank stare. Whether you’re undertaking your personal financial planning or contemplating wealth creation it is critical to plan for contingencies.
The first step when building an emergency fund is to identify an affordable savings budget. Start with a breakdown of your after-tax income and subtract all your expenses broken down as fixed (such as mortgage), variable (groceries) and discretionary (holidays and gifts). When you have identified the surplus you are well on the way to wealth creation. We suggest initially basing your plan on dedicating 50% of the surplus to allow for possible budgeting errors. I have modelled the financial outcomes based on weekly savings of $200.
An emergency fund can cover an event such as an accident or illness that leaves you unable to work for an extended period, a car breakdown or accident, losing your job or serious health issues. How much is needed depends on a number of conditions. A well-considered risk assessment will assist you in understanding the amount of money you should put away.
An obvious solution is to have enough capital in a safe bank account to cover all manner of emergencies. But it is not financially viable to do this, nor can anyone reasonably afford it. And setting aside capital for an emergency will also reduce the capital you have available for building wealth. You may find that by reserving capital for emergencies you are saving for an event that never occurs.
I recommend drawing up a list of possible emergencies. Then estimate the likelihood of each event, along with the potential impact or damage. Allocate a financial figure against each emergency to meet the cost.
No doubt your list will exceed your resourc- es. So weight the events in order of importance and discount the financial coverage applied to each event by a percentage based on its likelihood and likely financial impact. For events that are likely or would have a high financial impact you should protect yourself by transferring the risk to an insurance company through a policy.
When you have established how much you need to put away you can start saving. I recommend a figure of three months’ gross salary. When you achieve that first savings objective, re-evaluate your plan and make any changes. Meanwhile, you can carry on saving.
I do not necessarily advocate only reserving funds for emergencies. But I believe in building investment strategies that allow you to earmark certain funds for emergencies. My advice is to construct your investment strategy in a way that incorporates a component of your capital you could use for emergency funding but also contributes to your wealth creation. To achieve this you will need to balance principles of capital preservation, liquidity and accessibility with tax considerations, investor risk profile and return objectives. The appropriate combination will depend on your financial circumstances.
More common investment options include:
ONLINE SAVINGS ACCOUNT
These provide an interest rate return slightly higher than a regular savings account. Funds are at call and readily accessible. But the bank or financial institution may impose restrictions on the number of withdrawals you can make each month without penalty. It may also pay a lower interest rate or charge fees if you do not maintain a certain minimum monthly balance or make regular contributions.
TERM DEPOSIT
This form of investment, offered by nearly all banking institutions, allows you to contribute regularly over a fixed term. It has minimal costs and is regarded as simple, safe and low maintenance. However, it has a lower return than other types of investments and may not keep pace with inflation while interest rates are low. If you were to draw on the funds before maturity, your return is usually reduced.
MORTGAGE OFFSET
If you have a home loan that is not tax deductible and spare cash flow each month, it is a great idea to pay it into your mortgage directly. A more popular choice these days is to pay it into
an offset account, where you earn a return equivalent to your mortgage interest rate because you are reducing the loan principal, on which interest is calculated each month. In addition to saving you interest on your mortgage, you will still have access to the funds without being subject to market, timing or liquidity risk. An added benefit is that the earnings (loan interest savings) are not taxable.
SHARE FUNDS
A small amount of regular savings does not warrant a direct share investment because you do not have sufficient amounts to diversify appropriately or to meet minimum purchase (parcel) amounts. An increase in the availability and popularity of exchange traded funds (ETFs) has allowed small investors to access desired investments easily. A plan whereby you save your weekly amount into cash before regularly buying ETFs on the stockmarket at the end of each month allows access to investments that can generate profits through both income and capital growth. Other benefits of this strategy include the ability to gain access to broad market performance at a low cost, liquidity and reducing timing risk through the staggering of your purchase prices (dollar cost averaging). The risks include greater volatility and a potential reduction in the value of your capital, possibly when you need it the most. However, this form of investing has been proven to provide greater returns over the long term.
My advice depends greatly on your personal circumstances, stage in life and risk tolerance. I suggest a savings plan whereby you undertake to invest regularly into a portfolio of ETFs that would focus on generating capital growth over the medium to longer term. ETFs to consider include:
Vanguard Australian Shares Index (ASX: VAS). Vanguard Australian Property Securities Index (VAP). iShares S&P 500 (IVV) for exposure to the broad US market. iShares Global 100 (IOO).
Magellan Global Equities (MGE) for active global exposure.
There is a tweak to this strategy if you have an investment loan as well as a home loan. Instead of attributing the savings each week directly into the savings and investment strategy from your pay packet, you could make an additional home loan repayment first, before withdrawing from the investment loan side of your loan structure and using this to fund the borrowing-to-invest strategy. A further extension on this concept is to pay any dividends and profits you receive from the portfolio into the non-deductible home loan. Once again, any costs incurred in generating income are tax deductible so you can in turn borrow the costs of meeting interest payments, effectively capitalising interest costs. Just ensure you comply with the tax laws and guidelines.
This step would have the additional benefit of accelerating the repayment of your home loan (non-tax deductible) while increasing the investment loan balance proportionally. Over time this will have the added ancillary benefit in that it will change the loan profiles to be more tax effective. With a carefully managed cash flow program you could significantly accelerate the repayment of your non-tax deductible debt.
A projected estimate of the strategy is that after five years of saving $200 a week an investor would have around $64,000 in capital after tax. This equates to a net profit of around $10,000.