The Truth About Emergency Funds

What you know about emergency funds is just the tip of the iceberg!

Most of my friends will give me these textbook answers when I ask them about emergency funds:

• Sum of money set aside for urgent and unplanned life events
• 3-6 months of living expenses
• Kept in high-interest savings account or short term low-risk investments

These answers are not wrong, but it only applies strictly for an emergency fund. The problem is that most people equate emergency funds to liquid cash which they conveniently equate it to their cash held in the bank.

In this article, I will share my insights on the purpose and preparation of liquidity, not restricted to emergency funds. This article's intended audience are those in their 20s and 30s.

Onwards! On The Quest For Liquidity!

1. Why do we need liquidity?

It is right to say that liquidity is a MUST for urgent and unplanned life events. But liquidity is also important for planned life events.

Loss of job, medical emergencies (yourself or your loved ones, usually the latter), unplanned excess expenses (sometimes you do spend outside of your means and you choose not to compromise) are some of the unplanned events that you have to prepare for.

On the bright side, here are some reasons why you don't have to worry too much about some of these events:

When you lose your job, your urgency to find another one will be your number 1 priority (takes 2-6mths on average). Even during the unemployment, you'd find all ways and means to earn some kind of income (grab, or any other forms of freelancing). If it is a retrenchment, you will receive a severance package which can be pretty substantial.

When it comes to medical emergencies, Most of your own should be well-covered by your own insurance. The real emergency is when it happens to your loved ones who are not adequately insured. This can also be avoided if you ensure that they are covered sufficiently.

^Based on the above, it is no wonder that we are mislead to set aside only 3-6 months of living expenses/income for emergency funds which leads to setting aside only 3-6 months of liquidity.

2. How much should I really set aside for liquidity?

The 3-6 months guideline is flawed because your income can vary but the costs are fixed! If your income is $2k/mth, keeping 6 months liquid will only get you $12k of liquid cash. $12k will not help much in an unexpected medical emergency which can cost upwards of $10ks. This guideline is purely for someone to tide over their period of unemployment by providing for 6 months worth of income (assuming you live within your means!).

Instead let's think about what do we need liquidity for - events that require lump sum of cash upfront. Based on a typical Singaporean life: wedding, down payments (house, car etc), renovation, children's education, parent's allowance/medical needs, RETIREMENT (caps because most people don't realize that eventually they have to convert their investments to liquid cash for retirement income). For the sake of a clearer number, let's exclude retirement for now.

Estimates (assume you are sharing with your other half): Wedding (~$25k), house (CPF/~$30k), renovation (~$25k), children's education (~$150k X 2 kids), parent's welfare/medical (~$100k). Total you are looking at about at least $500k of cash to be kept liquid. Isn't that a hefty sum? How and where can I accumulate this amount of money?

3. How and where to accumulate/hold $500k in liquid cash?

Most people may keep a minimal amount in the bank and max out our investments because they feel that is the most efficient way to reach our goals. This article will stress on the importance of unconditional liquidity. While our investments may be fully liquid at anytime, we will be very unwilling to liquidate if we are in a loss position. In this case, there is a condition to be liquid (only if profit). It is even worse if liquidating at a loss is still not enough to put your kids through university. We can't wait for our investments to recover when the situation calls for our money (medical emergencies, children entering university).

You can continue this method of holding liquidity IF you can answer this question: "In 20 years, I will have $________ in my bank account/investment portfolio".

Having said all of that, let's come back to unconditional liquidity. Only cash/savings can be considered unconditional liquidity because it can be withdrawn and used at any time. However, we pay a price for this unconditional liquidity by earning interest rates that are below inflation rate.

How do we combine the idea of accumulating via cash/savings without being subjected to the cost of holding unconditional liquidity?

The answer is "Time'.

If we look at the various forms of savings, we have; saving accounts, fixed deposits, Singapore saving bonds (SSB), treasury bills, endowment plans and the list goes on.

The difference in these mediums, are the duration in which you commit to leave your money untouched.

Hold up! Ben, you mentioned that we're talking about unconditional liquidity. But some of these mediums are going to lock up my money!

You are right! Locking your money is the price you pay for better interest rates. That is why FDs yield better rates than saving accounts and endowment plans yield better rates than SSBs.

Our objective is:

• $500k unconditional liquidity at all times
• Earning at a decent rate >inflation rate

Only two simple points but difficult to achieve. Let's break it down.

Step 1: Identify what are the lump sums likely to be needed in the next 5 years (wedding, house, renovation, car etc).

Step 2: Identify what are the lump sums likely to be needed in 20 years time (children's education, parent's welfare/emergencies, retirement etc)

Step 3: Place and park your money to match short- and long-term needs (there is a very logical reason for doing so)

For example, short term needs most likely will not cross $100k. Keeping around $100k in the bank account is good enough to manage the wedding and renovation. The other $400k is needed further down the road, say in 20 years.

Instead of thinking that you need to lock down your money for 20 years, understand that you ONLY have 20 years to save that amount! If we want to save $400k by then, each year we have to put in $20k (for illustration purposes). If we miss 1 year, it means covering the shortfall in another year, adding up to $40k. A disciplined and committed approach is needed to make sure we reach our saving goals at a reasonable pace.

Ok time for an advertisement. The insurance companies came up with an awesome invention because they realize the problems with endowment plans. Endowment plans used to be single function products and tied to a purpose such as children's education or retirement. What happens if you don't need the money at the time of maturity? You will be stuck with $400K and you won't know where to place it. This is called 'reinvestment risk'.

With the new generation of endowment plans, we are now able to avoid this reinvestment risk as the plan allows us to keep the money in the plan up till about 100 years old, where it will continue to compound. At the same time, we are able to do partial withdrawals whenever we need the money. As such, the endowment plan has evolved into a multi-purpose plan which can be used for any events.

Most people have the traditional mindset of what an endowment plan is and play down on the effectiveness of this asset. Wake up already! You guys are missing out! There are no other assets out there that can serve the same purpose. Except maybe a bond (but you need $250k to buy one).

Conclusion

Whew I didn't expect to write this much for this article and if you made it here, thank you for your support!

To sum it up, unconditional liquidity is important because it is non-negotiable for life events. You can't tell your kids to defer their education or tell your parents to defer an emergency operation. These events are already something that can be foreseen and planned. If we can spread out our liquidity needs, it is much easier for us to start contributing towards each of the 'liquid' funds as early as possible.

Keep in mind that these are fixed plans. Once you start, you just need to continue contributing to these plans AND be assured that you have already prepared for big ticket items in your life. The bonus in doing so, allows you to take higher risks in your investments because you are solely focusing on excess returns. You no longer need to worry about not having enough for these life events and invest to your heart's content.

Always remember, there is a clear and distinct purpose for investment (returns), savings (liquidity) and insurance (protection). You should not simply lump them together because you will unknowingly neglect on the other components.

You may have plenty of burning questions because some of the things I have mentioned may sound contradictory. Please PM or comment and I will answer accordingly!

Financial planning is not just selling insurance. It is a complex planning process to cover all bases. Even as a finance graduate and a practicing adviser, it will and has always been a learning journey. I'll be happy to share more insights with you!

Ps. I like how far I have digressed from emergency funds haha