LOUISE FAIRSAVE: Investing an emergency fund
SOME READERS have queried the need to hold an emergency fund in cash given the low and falling interest rates offered on savings accounts.
They have been pointing out that each year their utility, grocery and personal care bills keep getting higher and higher, while the balance on their saving accounts will be growing lower and lower when taking inflation into account. Their implied question is: should an emergency fund be invested?
There is no single answer to this question, except to re-emphasise that in a crisis, liquidity (the ability to access quick cash) trumps growth (the rate of return on your cash balance) for an emergency fund. Ultimately, it comes down to the risk tolerance of the investor. Are you willing to invest your funds in the stock or bond market and possibly have a market change wipe out part or all of the value of your investment?
Yet inflation is a serious concern. There is no explicit bill for inflation. There is even argument among the economic gurus as to the prevailing inflation rate.
The other disconcerting issue is that it is difficult to accurately assess the effect of inflation on our savings balance. When we examine our savings balance at the end of the year, it has increased in absolute terms by the interest earned. However, there is no specific indicator as to how much that savings account balance has fallen in purchasing value.
The chief risk of holding cash is inflation, even at higher saving interest rates. So, depending on your disposition to investment risks, you may decide to apportion some part of your emergency fund to an investment.
A reasonable amount of the fund must be held in cash in order to provide quick access.
Two alternatives to an ordinary savings account are a credit union account or a money market account. Yet, the after-tax return on these accounts, although better than prevailing savings account rates, will likely be less than the inflation rate.
Another alternative savings vehicle is the Government Savings Bond. The minimum investment is $50 with other bond amounts of $100, $500, $1 000 and $5 000. These denominations provide flexibility in purchasing the bonds so that eventually when an emergency arises, the amount converted to cash can be minimised.
Bonds are usually available for purchase every three to six months and the interest earned is tax-free on an investment of $50 000 or less from
any one issue.
Government bonds are relatively liquid. They can be converted to cash on demand through any commercial bank.
One reader said that he worked around the low interest rates by paying down his credit union loan and by keeping his credit cards all free from any running balance. His argument is that, in an emergency, he will have quick access to cash from his credit union or through the use of his credit card. In the era of low interest rates, this approach is a commendable way of killing two birds with one stone: getting rid of debt and having access to cash if needed.
The point is that an emergency fund is essential. It must be readily accessible, keep up as much as possible with inflation and avoid risks.
Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters.
Her advice is general in nature. Readers should seek advice about their specific circumstances. Email: [email protected]