Illustration: Colin Daniel

This final column on investing a discretionary lump sum at retirement deals with the important issue of an emergency fund. An emergency fund is always a good thing, whether you are pre-retirement or in retirement, albeit for different reasons.

Before retirement you need an emergency fund primarily in case you lose your source of income for whatever reason, so that you will not have to resort to extreme measures such as cashing in retirement savings, stopping payments on risk life assurance or incurring expensive debt when you can least afford the repayments.

This need falls away in retirement, assuming you have an assured and sustainable pension income.

What does not change are life’s other emergencies. These can range from the less serious, such as your dishwasher packing up, to the far more serious and expensive, such as severe illness or an accident in which your motor vehicle is wiped out and you are injured.

Even if you are (hopefully) insured, it is unlikely that you will recover all your medical costs from your medical scheme or the full replacement cost of your motor vehicle.

If you do not have an emergency fund and you are already struggling to come out on your pension, you could face a major financial problem that may require you to reduce your standard of living.

Most sensible financial advisers suggest that an emergency fund should be equal to anywhere between three and six months’ income (after tax).

The most important things to consider when setting up an emergency fund are:

* Liquidity: the money must be available when you need it; and

* Inflation: you do not want the money in your fund to lose value. The return you receive should keep pace with inflation.

These two factors work in opposition to each other. The liquidity requirement limits the investment options available to you; and this in turn significantly reduces the returns you will receive on the money.

On the face of it, the need for availability limits your choices to bank savings accounts and term (short-term) deposits, as well as money market bank accounts and unit trust funds.

But currently, short-term interest rates are mainly below the inflation rate, so if you invest at these rates, the buying value of your emergency fund would be decreasing, meaning it would require a constant top-up from your pension income.

One thing you do not want to be doing with an emergency fund is paying anyone a commission for, say, investing the money in a unit trust money market account. If you are making a cash deposit, you should shop around for the best rates you can get. And once you have made the investment, you should keep your eyes open, because often one bank or money market fund will offer slightly better rates than another.

The point is it should be a do-it-yourself task.

Personal Finance is repeatedly asked for assistance when elderly people who have wisely set aside money in an emergency fund are approached by bank representatives who have been given access to their information, and told that they could and should be doing better for themselves with their money.

The bank representatives then suggest the money be moved into a high-risk unit trust fund with the argument that you can get your money out of a unit trust investment within 48 hours.

Quite correct, you can, but that rainy day when you need the money may also be the day that stock markets retreat by 10 or 20 percent.

It is also not that a unit trust fund is a wrong choice. The wisdom of the advice is governed by the percentage of your emergency money invested in the unit trust fund, as well as the risk level of the unit trust fund.

So you could divide your emergency money into various packets, as you are unlikely to need the entire amount on day one of the emergency. The argument for splitting the emergency money improves if you have a sizeable amount, say equal to six months of income.

For example, you could consider dividing the emergency pot like this:

* About 20 percent, for immediate use, in a money market account;

* About 40 percent in bank term deposits ranging from 60 to 90 days (if the rates offered are higher than a money market account); and

* The balance in a unit trust fund that offers limited exposure to higher-risk underlying investments, such as equities. You should opt for a balanced (asset allocation flexible) fund that invests across the asset classes of equities, property, bonds and cash to reduce risk, or one that aims to limit the downside risk to your capital.

You should definitely avoid pure equity funds with your emergency money.

Hopefully, better returns from the unit trust fund will make up for below-inflation interest rates.

In the unit trust sector, you will find a category called prudential asset allocation funds, which come with high, medium or low equity exposure.

The safer choice would be to place the allocated amount in a low equity fund, reducing your risk. These funds have a good track record and often return significantly more than you would get from a bank deposit. They also oft times come close to the returns of the high-equity funds.