This article was first published in the fourth-quarter 2014 edition of Personal Finance magazine.
Trouble comes in threes, the saying goes, but it feels like it walks around in gangs. Misfortunes may be randomly spaced over your lifetime, and perhaps you just notice them more when your car and computer break down in the same fortnight and then, before the next payday, the geyser bursts and, on top of that, you need expensive dental work. But there’s no denying that having a substantial emergency fund will help remove the financial stress of unexpected bills.
Traditionally, financial advisers recommend holding an amount equal to between three and six months of your living expenses in an emergency fund. Because the money needs to be accessed easily and quickly, it should be in a liquid asset.
All too often though, liquid assets are thought of as cash – keeping your emergency fund in a savings account with a low return. The problem with this is that inflation will eat away at the value of your savings and there will be an opportunity cost: you will lose the opportunity to earn a higher rate of return in another investment.
At a constant inflation rate of six percent, with an investment of R100 000 in a bank account at a nominal interest rate of 4.5 percent (and an effective rate of 4.59 percent), the buying power of your emergency fund would be reduced to just over R98 670 in a year and to about R96 000 in three years, says Danie Wessels, a financial adviser at financial advisory firm Martin Eksteen Jordaan Wessels.
“Financial risk aversion should be taken into account when determining the best way to invest emergency fund assets. However, in practice, funds allocated for guarding against income or expense shocks are usually invested in risk-free assets, regardless of risk aversion, because there is no volatility associated with these assets,” says an article, “Is an all-cash emergency fund strategy appropriate for all investors?”, by Janine Scott, Duncan Williams, John Gilliam and Jacob Sybrowsky, published in the Journal of Financial Planning in the United States in September 2013.
The researchers looked at the 40-year working lifespan of a hypothetical client whose goal was to accumulate enough wealth for a 30-year retirement while maintaining enough liquidity for income shocks. They modelled a six-month cash reserve invested in just two asset classes: equities and medium-term US treasuries (a proxy for cash). The performance period for both asset classes was 1926 to 2011, taking in a wide range of returns on both cash investments and equities. The asset class combinations ranged from having no equity investment at one extreme to a 100-percent equity investment at the other.
The researchers conclude that “the traditional recommendation of a cash-only emergency fund strategy is likely to reduce wealth over a lifetime. Furthermore, this strategy is less likely to meet emergency needs.
“Clients should be educated on the trade-offs between the psychological value of holding cash for emergencies and the opportunity to hold assets in a riskier portfolio that might provide increased retirement funding while better serving the precautionary motive.” (You can read the article on the US Financial Planning Association website, www.onefpa.org.)
However, the researchers caution that the analysis “does not apply to all households, but rather to more affluent clients of financial planners”. And it should be noted that the study factored in wage replacement of 40 percent for periods of unemployment provided by social security in the US. For South Africans, the unemployment safety net is extremely limited.
The article stresses that life stage, income volatility, level of disability insurance, financial risk aversion, number of earners in the household and the existing amount of after-tax savings are among the factors that should be considered when deciding on the optimal allocation of funds.
The South African financial planners Personal Finance spoke to agreed that a holistic approach – which includes taking into account life stage, tax and income level – is needed.
“For a person in the accumulating stage and while still employed, the emergency fund may need to be limited to three months’ living expenses,” says Jan-Carel Botha, a financial planner at Ultima Financial Planners, adding wryly that for many people a month’s living expenses equal a month’s net income.
Warren Ingram, a director at wealth manager Galileo Capital, says: “If you have a salary and a mortgage, an access bond is easily the best place to store emergency funds. The saving on interest will not generate taxable income and will represent the best rate on your money. If you have a rental property, it’s the same principle.”
Botha agrees: “People who have paid off most of the home loan before the full term (they have, say, only R10 000 left) can keep the bond open for the whole term. They can then dip into that in cases of emergency.
“You get a return of 9.25 percent if the mortgage rate is at prime and there is no tax. That’s a brilliant return.”
Botha says that with a money market return of, say, 5.5 percent, you still have to pay income tax on your interest once you exceed the applicable tax exemption of R23 800 if you are under the age of 65. (At this interest rate, you would need a total of about R433 000 in interest-earning investments before you would begin to pay tax on the interest.)
“People on a marginal tax rate of 35 percent would have to pay 35 percent of the 5.5-percent return back in income tax,” he says. “Thus you might end up with a 3.6-percent return versus the 9.25-percent saving on your bond.”
Frank Magwegwe, an accredited Certified Financial Planner and head of Momentum Personal Adviser Services, says that while an access bond is the “default best advice for ‘investing’ in emergency funds”, he feels strongly that the real returns are secondary to the two most important requirements when choosing a vehicle for your emergency fund: liquidity and ensuring the capital is guaranteed.
“The fact that by putting emergency savings in the access bond you earn a rate equivalent to the cost of the mortgage loan is secondary. This is important to understand, since in the situation of a consumer without a mortgage loan, the temptation is high to choose an investment vehicle that provides returns similar to putting the money in an access bond. However, such a consideration is misguided.”
Ingram agrees that your emergency fund is not intended to get the best possible growth. “View it as insurance,” he says. “It is intended to prevent you from getting into debt.”
Magwegwe advises that you keep your emergency fund in a bank savings account if you don’t have a mortgage bond and are not affluent (see “Small, nimble and guaranteed”, below).
“A high net worth consumer in South Africa without a mortgage loan is most likely to have paid off the mortgage and therefore can choose to take more risk with his or her emergency fund,” Magwegwe says.
He does not consider money market unit trust funds appropriate. “In my book, while these funds meet the liquidity requirement, they don’t meet the capital guarantee requirement. The recent impact of African Bank Investments Limited (Abil) paper on money market funds is a testament to this. Yes, money market funds are low-risk, but your capital is not guaranteed!”
Anyone who had money in a collective investment money market fund that was invested in Abil bonds would have had their capital reduced by 10 percent of the exposure of the funds to these bonds in the Reserve Bank’s rescue of the bank.
A money market bank account, though, is not a collective investment in which your funds are directly invested in bonds, and you would not be at risk of losing your capital unless the bank offering the account failed. However, a money market bank account is likely to earn you a lower return than a money market unit trust fund.
Ingram also sees a savings account as a vehicle, but for an older person without an access bond. “In a rising interest rate environment, an older person could get an interest rate of close to six or 6.5 percent. It’s probably not going to generate tax,” he says.
For a younger person without a bond, the situation is more complicated, because you are probably earning taxable income, Ingram says.
He considers unit trusts as sufficiently liquid, because you can access the funds within a week. He suggests choosing a low-risk portfolio, and mentions either a multi-asset income fund (which can allocate up to 10 percent to equities and 25 percent to listed property) or a cautious balanced fund (which limits its equity exposure to 40 percent and also invests in cash, government bonds and listed property).
He cautions that the interest-earning investments in these funds will earn taxable income for a young person, although less than an interest-earning bank deposit or money market fund would earn.
Wessels says that, in his opinion, better alternatives to cash-only investments include low-risk income funds and low-equity multi-asset funds.
“The objectives of these funds are to manage volatility and to provide real returns, typically two to three percentage points above the inflation rate. Recently, low-equity multi-asset funds yielded very high real returns (a real seven to eight percent) at extremely low volatilities,” Wessels says.
But he adds a strong word of caution. “These numbers should not be used for planning purposes. It would be safer to assume two to three percent real returns a year at higher volatility. Nonetheless, an investor should have more than a 70-percent chance of doing better than inflation and about the same probability of beating cash over a three-year period.”
Botha believes people are too conservative when it comes to emergency funds, although he is referring to a more affluent segment of society than Magwegwe is.
“There are opportunity costs of putting too much money in an investment that is too conservative – for example, having R500 000 in the money market,” Botha says.
He does point out that there is an argument for putting an emergency fund of R500 000 in a money market fund if there is a real, identifiable risk ahead – both the risk of a call on your finances and a market risk.
“This is especially so in times like the present, when the stock market looks expensive. If all your investments are in balanced funds and upwards in terms of exposure to equities, you might want to consider moving some assets into a stable fund. It depends on when you invested and whether markets are expensive.”
With that qualification, Botha believes most people can take on some volatility risk in a balanced fund. There is a chance that the market will be down when – or if – you need to draw money, but this must be weighed against the certainty of lower returns in a conservative investment.
“People randomly take the equivalent of three to six months’ or even two years’ expenditure and stick it in a fixed deposit – and then they don’t need the money and lose out in opportunity costs. Returns that are literally down by one to two percentage points a year can add up to as much as 25 percent over a person’s life. It is important to quantify that opportunity cost,” Botha says.
When Botha speaks on the topic, he more often uses the phrase “liquid discretionary investments” than “emergency funds”. He suggests that you look at your total wealth pot and ensure you have adequate liquid investments, both for emergencies and for changes in strategy. “We often get people who need to change their investment strategy – for example, they want to emigrate. Liquidity is not just about the car breaking down or the geyser bursting.”
He recommends diversity in your discretionary investments. “Funds need to be fairly widely diversified. This will include a fair portion of cash and will also be spread over two or three different funds. “But,” he adds, “it always depends on the strategy of the client.”
There are too many people, especially pensioners, with too little money in discretionary investments, Botha says.
“Make sure that not all your eggs are packed into pension investments, which are very fixed in terms of liquidity. Very often I find people retiring with 95 percent of their investments in their pension and five percent in discretionary investments. Now that a R500 000 portion of retirement savings can be withdrawn free of tax, the situation is much better. But, in many cases, it is still a very small percentage of the total assets. It might make better sense to go into the tax tier of 18 percent, if circumstances are right for that,” Botha says, referring to the 18-percent tax rate applied to a lump sum taken at retirement that is greater than R500 000 but less than R700 000. (Remember that the lump sum you can take on retirement is limited to two-thirds of your total savings, unless the total amount is below R150 000.)
One dynamic not yet mentioned is your ability to create and stick to a household budget that suits your circumstances. A good budget may reduce the risk of you encountering an “emergency”, because it should include provision for the likes of vehicle repairs and maintenance and expensive dentistry. At the same time, it will help you to save for an emergency fund. If you have enough income, you can budget for holidays and gadgets, reducing the temptation to dip into your emergency savings for these.
“Thinking about how to invest emergency funds is great, since it means the consumer is building the fund. The reality, however, is that the majority of South African households don’t even have half-a-month to a month’s net salary available for emergencies. The main reason for this is the lack of monthly budgeting and, in particular, a poor grasp of expenses,” Magwegwe says.
One last piece of advice. It’s funny how often burst geysers are mentioned in discussions and in the literature about emergency funds. Maybe you should keep an eye on yours.
SMALL, NIMBLE AND GUARANTEED
Keeping your emergency fund in cash may be attractive for those without an access bond, because a bank savings account ensures your savings are liquid and not subject to volatility. But in the current climate it is almost impossible (but not entirely so) to keep pace with inflation while saving at a bank.
The inflation rate in May and June, as measured by the Consumer Price Index, was 6.6 percent, but it slowed to 6.3 percent in July. Your personal inflation rate may be higher, especially if your expenditure is heavily weighted towards food, fuel, education and medical costs.
Financial advisers suggest your emergency fund should equal three to six months’ worth of living expenses. Let us put the amount at R100 000, although obviously your own circumstances will determine the size of your fund.
If you sought a bank account at the best interest rate and with immediate access to the whole amount, the best you could get on R100 000 would be 5.75 percent at Nedbank in its Money Trader account. At the current inflation rate, you would start losing money the moment you invested.
But is it necessary to have the entire R100 000 available immediately? Large calls on your savings, such as retrenchment or a serious medical treatment not fully covered by your medical scheme, seldom require you to have the entire amount available immediately.
With this in mind, you may consider splitting your fund into a small, liquid, non-volatile portion invested in a bank account and a much larger portion in an income fund or low-equity fund. You would still be exposed to a below-inflation return, but a far smaller proportion of your capital would suffer.
Danie Wessels, a financial planner at financial advisory firm Martin Eksteen Jordaan Wessels, agrees that it makes sense to split your fund. He suggests putting “perhaps R20 000 (depending on your circumstances) in an easily accessible (savings) account and the balance into liquid collective investments such as a low-risk multi-asset income fund or a multi-asset low-equity fund”.
If the idea of a two-tier emergency fund appeals to you, or if you are starting to save for your emergency fund, below are some options for investing R10 000 or R20 000 in a bank account. Those amounts would cover the smaller emergencies that confront us and can be paid for by credit card, which increases the range of investment options to include notice deposits. The credit card debt can then be repaid without incurring interest.
Some banks have recognised the need for accounts that give you a better return while accommodating your need to access savings. Some have introduced fixed-deposit accounts that allow you to withdraw a portion of your funds before the fixed term is up.
Personal Finance canvassed the offerings of the main retail banks for the best interest rates available on deposits of up to R20 000, because you may prefer to save at the bank with which you have a transactional account. Where relevant we have provided the bands at which different interest rates apply, because making a withdrawal may push you into a lower interest band. All rates quoted are nominal annual rates and were correct on August 19.
Depositor Plus requires a minimum initial deposit of R15 000. The interest rate on amounts between R15 000 and R25 000 is 4.45 percent.
Notice Select allows you to choose the notice period and the portion of the investment you want to have available on demand, and this determines your interest rate. There is a minimum deposit of R1 000 and additional deposits into the account can be made at any time, with no deposit fees. There are many more combinations than those selected below, but, for the purposes of our scenario, on amounts from R1 000 to R24 999, the following rates apply:
* 32-day notice period with half the capital available without notice: 4.5 percent;
* 32-day notice period with no amount available without notice: 4.75 percent;
* 60-day notice period with half the capital available without notice: 4.6 percent; and
* 90-day notice period with half the capital available without notice: 4.7 percent.
* Seven-day call account. The interest rate is 5.25 percent. The bank cautions that this is a limited offer and may be discontinued at any time at its discretion. Funds invested are available on demand seven business days after investment. You cannot transact on this account via internet banking, but you can view the balance. The minimum balance is R5 000.
* 41-day notice account. The rate is 5.45 percent. A minimum deposit of R5 000 is required. Additional funds can be transferred into the account at any time. If you give the bank written notice, you can withdraw part of your funds once the 41-day notice period has elapsed. The rest can remain on deposit at the same interest rate.
* Fixed deposit investment account. A one-month deposit of R10 000 will earn 5.3 percent. Notice of withdrawal must be given in writing, and Bidvest says that if it does not receive instructions about where to transfer the funds once the notice period has lapsed, it will transfer the funds into a call account held at the bank on your behalf. (The call account will attract standard call interest rates.) This effectively means that if you keep a portion of your emergency fund in the one-month fixed deposit, you will have to notify the bank every month you want to roll over the investment. The minimum investment amount is R5 000.
Up to R9 999: 4.4 percent
R10 000 to R24 999: 4.5 percent
This savings account pays interest according to how much you save, and the funds are available at any time. There is a monthly bank charge of R5.
First National Bank
My Notice Deposit
R1 000 to R9 999: 2.55 percent
R10 000 to R19 999: 3.75 percent
R20 000 to R49 999: 4.25 percent
There is no withdrawal fee if you give notice of 45 days or more, but if you give notice of between one and 44 days, there is a withdrawal charge. If you need the cash immediately and give notice of between one and nine days, the cost will be 2.5 percent of the withdrawal amount. The cost drops by half a percentage point for every additional nine days’ notice, down to 0.5 percent for notice of 40 to 44 days. The minimum deposit is R1 000.
Flexi Fixed Deposit
R100 to R9 999: 2.25 percent on three-month term
R10 000 to R99 999: 4.50 percent on three-month term
You can make two free withdrawals (at one day’s notice) over the term of the investment, each of a maximum of 15 percent of the available balance. The bank says that with a R10 000 deposit, you could access a maximum of R1 485 and then R1 262 (excluding the effect of interest) in the three-month period. When the investment period expires, the funds will be automatically reinvested at the prevailing interest rate in the same account unless you give instructions as to how they should be handled. The minimum opening deposit is R100.
R5 000 to R9 999: 4.25 percent
R10 000 to R19 999: 4.75 percent
R20 000 to R49 999: 5.25 percent
You need a balance of at least R5 000.
EasyAccess Deposit allows you to withdraw half your original capital and offers three-, six- 12- and 18-month deposit periods. The annual interest on the three-month period is 5.5 percent and on 18 months is 6.6 percent. Although fixed deposits over long periods such as 18 months are contrary to the entire premise of emergency funds, in this case you would have access to half your capital immediately at a rate that keeps pace with inflation. A balance of R2 000 is required, but thereafter the interest rate is not determined by the amount you invest. When the term expires, the investment is automatically renewed in the same account for the same term.
Money Trader, with its 5.75-percent interest rate, is available only on deposits of R50 000 or more.
Up to R9 999: 2.15 percent
R10 000 to R24 999: 2.85 percent
This account is intended more as a vehicle for accumulating savings than storing them, but it may be beneficial if you are building your emergency fund because you will be paid an extra one percentage point interest if you select a savings target and reach it.
32-day notice deposit
R250 to R9 999: 2.75 percent
R10 000 to R24 999: 3.25 percent
The minimum deposit is R250.
Up to R4 999: 0 percent
R5 000 to R19 999: 2.5 percent
R20 000 to R49 999: 3.75 percent
This is a hybrid investment and transactional account, with no exposure to equity markets, and guaranteed capital and rates.
IT’S TEMPTING, BUT DON’T DIP INTO YOUR FUND
While it is crucial that an emergency fund is liquid, the drawback of having such quick and easy access to your money is obvious.
“The mistake is when people use it for holidays,” Warren Ingram, a director at Galileo Capital, says.
He need not have stopped at holidays. An iPad or a new car when your current one seems a bit tired … there is no end to the number of things you can convince yourself are emergency needs. In the right frame of mind, you don’t even need to define it as an emergency. Or a need.
But you may simply fall victim to poor budgeting and too many calls on your limited resources.
Frank Magwegwe, who holds the Certified Financial Planner accreditation and is head of Momentum Personal Advisory Services, says: “In my experience, most consumers don’t have the required discipline to build an emergency fund, since, with easy access to the money, they convince themselves that it is okay to dip into the fund after overspending in a given month.”
The trick is to create all sorts of psychological barriers to accessing your emergency fund. One way to do this is clearly to define it as such. This can be difficult if you are “storing” it in your access bond.
“You need to physically put money into the mortgage account and identify that as money to use in an emergency,” Ingram says.
By “physically put” he means that while you are building the emergency fund you need to make the transfer of money separate from the automatic payment of your mortgage. It would also be helpful to keep a running total of the balance of your emergency fund as it is supplemented and depleted.
Danie Wessels, a financial planner at financial advisory firm Martin Eksteen Jordaan Wessels, says that if you have invested a large portion of your emergency fund in low-risk, liquid collective investments, it is psychologically that much more “difficult” to access the funds than if they can be accessed via online transfers. “This is simply because one has to submit a redemption form every time, and that ‘extra effort’ keeps one from redeeming the emergency funds on a regular basis. Thus, one makes it slightly more difficult to fall prey to one’s own impulsive decisions.”
Magwegwe recommends a bank account as the vehicle both to build an emergency fund and as the place to keep it once it has reached the size you want. This applies to people who do not have a bond and are not affluent.
“Open a separate savings account for the emergency fund,” he says. “Ideally, the emergency savings account bank card must be put away, to be accessed only when an emergency arises and a withdrawal must be made.”
Depending on how far you have progressed towards meeting the goals of saving first three and then six months’ living expenses, he recommends keeping a portion in a savings account and the rest in a 32-day notice account, which is a little more difficult to access while still meeting the liquidity requirement.
New bank products allow partial withdrawals from notice and fixed-deposit accounts, so you may find one that suits your needs.
Being accountable to someone is another strategy to help you build and maintain your fund, Magwegwe says.
“You need some sort of financial adviser to help you stay focused on that goal, someone you meet with regularly and who will ask about it.”
If monthly meetings with an adviser are not feasible – or even if they are – you can use the family context to change a habit, Magwegwe says. “Have discussions with the family, particularly your spouse, and talk about the budget and the emergency fund.”