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Why is Contingency Fund so important? - Outside View by PersonalFN

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Why is Contingency Fund so important?
May 15, 2013

One of our financial Planning client Mr. X (Name changed to protect privacy) working with an IT firm as a consultant was informed about the slowdown in IT industry. The consequences of slowdown in IT industry can be so dramatic that he might end up losing his job in next couple of months. God forbid, but if he really does lose his job, the financial goals which he dreams off such as cosy retired life, giving the best to children - be it education or even getting them married-off well amongst others; may all go haywire, but more concerning would be funding his day-to-day expenses to run a home including the EMI for a home loan.

Mr. X might stop investing for his financial goals till the time he finds a new job but his regular expenses such as household Expense of Rs. 25,000 p.m., medical Expense of Rs. 5,000 p.m., child School Fees of Rs. 10,000 p.m. and EMI on home loan of Rs. 15,000 p.m. has to be met in any case. Cumulating these entire expenses he cannot avoid paying a sum of Rs. 55,000 p.m. and other regular expenses.

Therefore, you see a need arises to primarily have a contingency fund to confront such a situation and embarrassments. Typically a contingency fund consists of 6 to 24 months of regular expenses. This includes all necessary expenses, but can exclude luxuries.

Contingency Fund Requirement of Mr. X
Expenses Amount p.m. (Rs)
Household Expense 25,000
Medical Expense 5,000
Child School Fees 10,000
EMI 15,000
Total Expenses 55,000
6 months Expenses 330,000
24 months Expenses 1,320,000

In the case of Mr. X, 6 months of expenses would be Rs. 3,30,000, and 24 months of expenses if Mr. X chooses to be conservative in his outlook, would be Rs. 13,20,000.

Many a times when people first hear that it is important to keep at least 6 months and up to 24 months of expenses aside as a contingency fund, they tend to think of it as a large sum. Often the reasoning is, this money is just lying idle, and that means it is losing out on what it could earn if deployed into an asset classes such as equity, debt and gold. In order to utilize your contingency fund effectively, you could also look at flexi deposits offered by banks these days.

But that's not what a contingency fund is for.

You see, the purpose of having a contingency fund is to take care of your family and your expenses in an emergency situation, such as loss of job, markets crashing, medical emergency or any unfortunate event that come with an economic loss for some time.

Often there are financial obligations that are absolutely must to meet no matter what your professional or personal situation is. Loan EMIs are a prime example. This is why you must have a contingency fund. So that if for some reason, your cash inflows reduce or halt or your expenses suddenly shoot up more than your income, you don't have to worry because you have anticipated this and have set the funds aside. In the case of Mr. X, he chose to build a 1 year contingency fund because his cash flow uncertainty was higher, being a consultant. This 1 year of contingency fund will help him to take care of his regular expenses in case he really loses his job and will also give him time to find a suitable job in next 1 year without worrying much about his regular expenses.

So what to do if you don't have a contingency fund?

Your first step should be to start saving for at least 6 months of your regular expenses before investing for any financial goals and keep it in a savings bank account or if you want a better return than putting money into a savings bank account, then opt for sweep in account, flexi deposit or liquid funds. Once 6 months of your contingency funds are available then your next aim should be to increase it to 12 or 24 months of regular expenses which can be done in phased manner over a period of time. If you have any EMIs you must remember to include them in your regular expenses when building up your contingency fund.

Remember, there are events such as job loss or illness that can get in the way of your regular cash flows, but this should not get in the way of letting you achieve your life goals with consistent investments into the right investment avenues.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


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