How Long Should I Maintain an Emergency Fund?

Published: July 8, 2013 at 8:00 am

Last Updated on

This intriguing question was recently asked by my friend. Intriguing because it can be answered in two ways:

  • In one word!
  • Or by considering all possible ways an emergency fund would see some action!

By action, I of course refer to emergencies only! American financial coach Dave Ramsey, often says, “Christmas is not an emergency!”

Setting up an emergency fund is the first  item on the fiscal fitness checklist. Just how much should the emergency fund be? You can’t make a calculator to address this one! It depends on whether you are a pessimist or optimist! It depends on the kind of bad things that have happen to you or to people you know and the frequency of their occurrence!

When experts say that one needs an emergency fund equal to about 3-6 months expenses, it must be kept in mind that they are addressing people with zero emergency fund so that something is better than nothing. An emergency fund worth about 3-6 months expenses is not bad at all but will only handle a limited range of emergencies: keeping you afloat for a few months when the dreaded pink slip arrives (ably supported of course by a severance package, assuming you receive one!); car repairs, appliance repairs and the like. In this context it is very important to remember that ‘expenses’ includes all EMIs.

Most people are under the impression that such an emergency fund (3-6 months worth …) along with adequate pure term life insurance and adequate health insurance (employer based +/- private) is enough to tackle all the problems that life can throw at you.

Such people have either been lucky (so far) and/or are too young to have experienced/seen/heard of anything bad. Good for them. Unfortunately, past performance is not … well, you know the drill!

Most people use the term ‘cashless’ when health insurance is discussed like it is some soft of panacea – the cure for all hospitalization related money issues. A cashless claim is just one way of claiming hospital bills and is applicable only under certain circumstances. An insurer has to permit a cashless claim before treatment is started (other than basic first aid and stabilization)  and is often rejected! This implies that the patient will have to pay the bills and then make a reimbursement claim (in the hope that it will be honored!).

With medical expenses increasing annually at an alarming rate (15-20% is a conservative estimate!) would an emergency fund worth just 3-6 months expenses suffice under such circumstances? It is prudent to have liquid cash worth at least 50% of your mediclaim cover. Since it is important to increase the mediclaim coverage annually by as much as you can, the same applies to this segment of the emergency fund!

Many who take term insurance believe that they are not going to die anytime soon, and/or in case that they do die, all that their nominee has to do is to make a claim application and the insured amount will be dispensed forthwith! I would strongly urge such people to read this: The Games Life Insurers Play!

Never forget this: Term insurance is the cheapest of all insurance plans. At the same time, the sum insured in a term plan is the highest. Therefore it is will be subject to close scrutiny. Therefore delays in claim settlement are quite common for a variety of reasons (how one dies, when one dies, nominee dead or injured etc. etc. etc.). So when you take a term plan ensure that, over a period of time, you slowly build an emergency corpus that will cover at least 12-15 months of expenses in the event of your death. Hopefully this buffer will provide enough time for all parties (insurer, nominee and ombudsman, if needed) to get the claim settled successfully. The nominee can handle the claim settlement process with a calm and clear mind. Even if for some reason the claim is not settled it allows your loved ones some time to arrange for alternative sources of income.

If you think that an emergency fund is a like a guardian angel on part time duty when you are employed, you are right. Provided of course you realize that the moment you retire, the guardian angel is promoted to a full-time employee! Every retirement calculator is based on assumptions and unless you get close to retirement it will not be possible to predict with any accuracy how much you actually need to generate an adequate pension/annuity to sustain you.

What can be said with a great degree of certainty is that the emergency fund will be a central part in ensuring your financial independence in retired life. When you are employed, a car break-down is less serious than a pink slip. A pink slip is less serious than death. Such distinctions cannot be made in retirement. When you are retired, any unexpected  large expense will slowly but surely eat up the life of your retirement corpus. So I would like to conservatively guess that an emergency fund worth about 2 years of expenses during retirement would be needed, in addition to a decent corpus for medical emergencies alone! If your retirement is a couple of decades away, you have time to build this. Just get started!

To summarize, here is my version of a decent emergency fund
  • Sum equal to about 3-6 months emis. Leave it be even after you are debt free!
  • Sum equal to 12-15 months household expenses. Six months to start with and then built up slowly
  • Sum equal to at least 50% of mediclaim sum assured. Requires constant contribution!
  • Any excess funds after accounting for investments and expenses (in that order!). Contributions lasting a lifetime!
  • Use simple products like a savings bank account and liquid fund for meeting everyday emergencies. Avoid complicated products like sweep-in (FD-linked) bank accounts. Remember returns are not important for an emergency fund. Safety, liquidity and simple tax rules are.

Never, never forget:

Investing for retirement and a corpus to meet medical emergencies in retirement are non-negotiable financial goals of utmost priority.

Always, always remember:

murphy

I started the post by stating that the titular question can be answered in one word. What do you think that is ? Do you agree with my version of the emergency fund? Do you think I am bit too pessimistic?

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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