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By Stefan Janse van Vuuren*
A savings account for emergencies has long been listed by advisors as one of the cornerstones of any successful personal financial plan/strategy. An emergency fund lends investors the comfort of knowing they have a “safety cushion” in case they lose their primary source of income or have unexpected expenses. However, job losses on the scale brought about by the impact of COVID-19 has revealed how few individuals have an emergency fund and how underfunded the savings accounts are of those who do.
Why you need an emergency fund
Lockdown measures, in SA and several other countries, have left many people, families, and businesses without a source of income. Leaving those who did not save for the proverbial “rainy day” exposed, rueing their lack of emergency funds as the COVID-19 pandemic turned the mostly unexpected “what if” scenario into harsh reality.
Having an emergency fund is vital to any individual’s financial strategy. Apart from losing your job or main source of income, unforeseen expenses such as medical bills, vehicle and household repairs, funeral costs or even a child’s sport tour may place any household budget under pressure if there is nothing left after having paid regular expenses. Yet households living from pay cheque to pay cheque is a common reality. This may force individuals to sell other investments, take out a loan or use credit card debt to fund unexpected expenses, delaying growth on those investments for future consumption.
The required amount saved in an emergency fund differs from person to person, but most advisors have long argued that the ideal amount required to provide security against a sudden loss of income or surprise expenses should be enough to cover 3 to 6 months living expenses. Life is costly and budgets are under pressure in current times, but it is important that you start somewhere, irrespective of the size of your monthly contribution to an emergency fund.
Options for an emergency fund
The act of saving means you choose future consumption over current consumption and ideally you would like to be rewarded for showing discipline and self-control by earning interest on the money saved.
When saving for emergency fund purposes there are a few factors to consider:
Instant Access – The money needs to be kept in liquid investments that allow easy access and limited withdrawal costs.
Stability – Ideally you want to be invested in an account or product that offers stable returns with limited market volatility, as you might need to use these funds during times of market turbulence.
Inflation – As mentioned, the act of saving means deferring expenditure into the future, therefore savings need to outgrow inflation. If not, the purchasing power diminishes as time passes, which defeats the purpose of saving. The opportunity cost is not just the loss of purchasing power but the actual loss of growth if you are saving via investment options that do not offer inflation-beating returns.
What are the options?
1. Money market linked savings account:
The returns from money market investments closely follow the repo rate. Therefore, thanks to SA’s high repo rate over the last 5 years, conventional money market accounts available at banks have delivered excellent, inflation-beating returns. The South African Reserve Bank (SARB) uses the repo rate to control the inflation rate in SA, increasing the repo rate if inflation increases and cutting the repo rate if inflation falls. The Covid-19 pandemic and recent decline of the oil price has decreased SA’s inflation rate, meaning the SARB could cut the repo rate in the hope of stimulating SA’s shrinking economy. And so, it has done – cutting the repo rate by 0.5% to 3.75%, a record low (see graph), at its May meeting, bringing the total rate cuts for the year to 2.75%. Analyst forecasts predicts inflation to remain subdued, with the SARB expecting inflation to remain below 4.5%, the midpoint of its 3-6% target band, at least until 2022. With inflation under control, commentary from SARB suggests two additional 0.25% rate cuts can be expected in the two remaining quarters of 2020.
This does not bode well for money market investments as their returns lag the change in the repo rate. Therefore, we can expect their returns to trend downwards towards the 4% mark as it adjusts for the cut in repo rates. The last time we saw the SARB slash repo rates as aggressively as it has done recently, was during the global financial crisis (GFC) of 2008. The period, thereafter, saw the average money market investment deliver negative real returns, failing to beat inflation up until mid-2014.
The returns from money market investments:
2. A tailormade fund for emergency savings fund:
Financial management specialists have devised different funds that can offer returns superior to the readily available off-the-shelf or retail offerings. One such fund is an Emergency Savings Fund (ESF) developed by Brenthurst Wealth, which invests in an array of flexible, multi-asset income funds, offering a savings solution that delivers stable, inflation-beating returns.
The aim of the Brenthurst ESF is to provide investors with income growth that outperform money market products with low risk of capital loss in the short term and moderate levels of capital growth in the long term.
The Brenthurst ESF aims to achieve this by investing in actively managed income funds with flexible mandates, that have access to a broad range of interest-bearing instruments (including government and corporate bonds, convertible bonds, debentures, corporate debt, cash deposits and money market instruments) as well as preference shares, equity securities, property securities, assets in liquid form and derivatives.
By diversifying across fund managers and asset classes (within the above mentioned investment universe), the Brenthurst ESF accesses additional sources of returns, whilst also diversifying risks, allowing investors to have the necessary stability and capital availability that is required of an emergency fund.
If there is one lesson that 2020 delivered, it is that the future will surprise and predicting what will happen is near impossible. That does not mean, however, that inaction is the most appropriate response. Even in times of uncertainty, planning for the future remains important.
Read more about how to approach a sound financial strategy here: Investment Planning
- Stefan Janse van Vuuren, financial advisor, Brenthurst Wealth.
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