Build a better bomb-proof bunker for your money

The dos, don’ts, wheres, and hows of setting up an emergency fund

Build a better bomb-proof bunker for your money

When mulling over your options for places to build your emergency fund, you should bear in mind a couple of fundamental principles that we’ve discussed in recent articles.

Firstly, beat inflation.

The first is to earn a worthwhile rate of interest. The rate is worthwhile when it compensates you for the effects of inflation, otherwise your savings will be eroded in purchasing power terms. Remember that it’s not about earning a fantastic return on your cash, rather it’s about preserving the value of your savings so that should the time come, its worth at least as much as the day you put it away.

Secondly, don’t be paralyzed by choice.

There are many options for saving cash and provided your choice ticks a few basic boxes, you’re free to do what works for you. Choosing the perfect place to grow your savings is not nearly as important as finding a place at all.

Two vital characteristics of an Emergency Fund:

  • Liquidity. In financial terms, “liquid” just means easily accessible, and that’s important in an emergency. A month’s delay in getting your money out isn’t going to help your car get fixed promptly.
  • Capital guarantee. This means that however you structure your emergency fund, it shouldn’t be susceptible to wild fluctuations in value. Fluctuations you might see on the stock exchange, for example. It should be as stable and reliable as possible.

So where do I find something that meets these criteria?

There are three categories of savings options you can explore.

Money market unit trusts

A money market unit trust is a unit trust that invests in cash or cash equivalent financial instruments. Put simply, it’s like a glorified savings account, but it does not sit with a bank[1].

You can access your money in 24 to 48 hours and as each unit in the unit trust is permanently fixed at a value of R1.00, the general experience[2] is that you should never be subject to volatility in the price of the unit. Interest is earned on your savings like it would in a traditional bank account and you have the choice whether to have the interest paid out or to be reinvested.

Choices, choices.

There are dozens of money market unit trusts available. A simple internet search will yield many results.

To open an account, you will be required to provide your usual personal information and transfer money to the unit trust management company’s account. You will be issued with regular statements and be able to track your interest earned and the value of your savings.

Fees are generally quite low in a money market unit trust. A quick look now at the current range of fees charged shows fees ranging from 0.30% to 0.58% p.a. Incl VAT. Money market unit trusts are a super competitive product offering and every last 0.01% counts. Some funds charge half the annual management fee that others do in order to offer a superior rate and to attract more business.

Six of one, half-dozen of the other.

It is this author’s opinion that almost all money market unit trusts are near perfect substitutes for each other. You can fairly safely judge them on quoted performance and their reputation for administration.

The rate quoted by the unit trust will generally be after fees, so you could choose to focus only on the rate; comparing apples with apples.

Don’t pay to give someone money.

There should be no upfront fee if you invest directly into the unit trust – that would be like making a deposit at a bank and the bank immediately taking some money as a fee – for doing nothing! If you find a place for your emergency fund that wants to charge you an upfront fee for placing your cash with them, email us their details and please move onto your plan B.

Do some relaxed legwork, and know what you need to get started.

Do some searching and see what you can find. Who is offering what rates? Be aware that there is generally a minimum investment amount for money market unit trusts. These range on average from R10,000 to R25,000 but can be much more. You may need to use your regular bank account to build up some cash, before moving it to the money market unit trust of your choice. However, once your money market unit trust is up and running, you can continue to make small additions to it over time.

The usual suspects.

To help you out a bit and while we come up with a more permanent solution, here are the names[3] of some money market unit trusts you could consider, but please do your own homework – that’s the finance DIY way. If you have an existing relationship with any of these companies, visit their website and see what their money market unit trust offers you.

  • Absa
  • Allan Gray
  • Cadiz
  • Coronation
  • Discovery
  • Glacier
  • Momentum
  • Nedbank
  • Old Mutual
  • Prudential
  • PSG
  • RECM
  • Standard Bank

Bank accounts

For those of you who value your relationship with your bank, and who may prefer to park your emergency fund with them, some banks do offer savings accounts that can compete with money market unit trusts in terms of having all the important characteristics and principles that are so essential for a good emergency fund. We must however caution you that the minimum amounts required by banks to offer you a meaningful return often far exceed a money market unit trust’s requirements.

Banks are not known for moving quickly.

Ensure also that you have immediate (24-48 hours) access to your cash if need be. A lot of the banks’ savings products will tie you into 30, 60 or 90 days.

Banks may restrict your ability to move money in and out to only a few instances per month as they don’t want you to treat it like a cheque account. It’s unlikely that you’ll need to be drawing and depositing money that frequently into your emergency fund, but if this is a possibility then consider this possible restriction.

Approach your bank. See what options they have for your emergency fund. In some select scenarios, banks will be able to offer you something, but likely nothing that can compare to the rates offered by a money market unit trust. Then again, it’s not always about the rate, or is it?

Stable Funds, for the true finance DIY enthusiast.

Lastly there are the stable funds. Stable funds are also unit trusts but don’t only contain cash or cash equivalent financial instruments; they also contain some shares and maybe property. The idea of a stable fund is to shelter investors from volatility as best it can and to minimise losses over the medium term.

Per its name, a stable fund offers investors more ‘stable’ returns. There should be no large spikes or dips but as a stable fund assumes more risk by virtue of it holding shares (something we’ll touch on in future articles), there is an implied expectation that it will provide returns in excess of a money market unit trust.

Spread your bets between Money Market and Stable Fund.

If your emergency fund is larger, either because your expense base is big, or because you hold a higher number of months’ worth of expenses, you can consider putting half your emergency fund into a money market unit trust and half into a stable fund or similar product.

The 50% allocation to a stable fund could provide a small but potentially meaningful increase in the overall return on your combined emergency fund. Any potential for increased volatility through your exposure to the stable fund is diluted given that only half your money is allocated to it.

If the thought of opening two accounts stresses you out: relax.

The use of a stable fund, if at all confusing, can be left for another day. If you find a money market unit trust that works for you and you don’t fancy the complexity of additional accounts, keep it simple. If you’re up for some additional learning later in your finance DIY quest, you can come back to this article and investigate things further.

Three major misconceptions about emergency fund alternatives.

In prior articles we mentioned that we’d deal with two misleading ideas around possible sources for your emergency fund. Now that you hopefully appreciate that liquidity is crucial and that immediate access to your money is not negotiable, let’s deal with them.

Using your bond as an emergency fund.

Some people feel that using surplus cash in your home bond is a great way to access large chunks of cash in a hurry. The house owner who has been paying off their bond diligently over the last several years may have what appears to be a very plush and easily accessible supply of money at their disposal.

The idea is that if cash is needed, you simply move money from your bond to your transactional account and problem solved. Sometimes this can be done through online banking if you have an access bond, and sometimes you need to formally approach your bank.

Drawing from your bond can get out of hand.

This may work for small amounts, but the complication is for larger sums. For a bank to advance you additional money, they need to satisfy themselves that you can in fact service the larger monthly bond payment. If you suddenly want to draw R100,000 from your bond, your bank may require you to repeat an affordability exercise to prove that you can in fact meet the demands of an increased monthly bond repayment[4]. If you have just lost your job, how will you show the bank that you can service the larger monthly instalment, let alone any instalment on a sustainable basis?

Don’t get stuck in the bond credit trap.

People are also under the impression that access to this line of credit is their right – but it’s not! The bank is under no obligation to advance this money to you. Your so called ‘emergency fund’ is entirely at the discretion of someone else.

Apart from accessing this line of credit in the first place, drawing from your bond means your monthly instalments will likely increase, adding further to your cash flow constraints. When you recover from the financial effects of your emergency, ask yourself how likely is it that you will replace the money you drew from your bond?

Your credit card is a golden ticket to the credit trap.

The same goes for the use of a credit card. An available balance of R50,000 on a credit card is a naïve choice for an emergency fund. Just as easily as you applied for your increased credit limit, so the bank can take it away. Worse still, banks charge some pretty serious rates of interest on outstanding unsecured balances.

While dealing with your emergency, you’ll now be required to pay the bank interest on your new loan, as well as make a minimum monthly repayment on the outstanding balance, anything from 5% to 10% per month. Hardly the scenario you want, having just emerged from a financial catastrophe.

Using a credit card really only shifts the financial effects of your emergency issue to a more formal arrangement of unsecured lending. It does not resolve the issue.

Don’t shares give higher returns?

Those who have a short-term memory or who are positively upbeat all the time, might far rather put all their money into a unit trust containing only shares, with the belief that they’ll get a much better return from the stock market than they would from cash.

While shares have generally provided superior returns when compared to cash over the longer term[5], this comes at the cost of volatility.

Shares have generally performed very well these last several years, but remember that the South African stock exchange lost nearly half its value in 2008 during the global financial crisis. Had you lost your job in 2008 or 2009, which many people did, your emergency fund linked to the stock market would only be worth about half as much as it was several months’ before. Suddenly your three month buffer becomes a forty five day buffer.

Emergency funds are made to reduce risk, not increase it.

Chasing a higher return comes with an increase in risk; this is how capital markets work. An emergency fund is not the place for you to juggle the risk-reward relationship, nor to learn its lessons.

An emergency fund should instil a sense of certainty in you. Certain that you have cash to meet the financial challenges that may arise, certain that you have a buffer to live off of when you need it. There is nothing to be certain about when it comes expecting your bank to care or relying on unsecured lines of credit.

Get out there and go completely crazy responsible.

Some added benefits of using a money market unit trust is the built-in 24–48 hour delay in gaining access to your money.

If money isn’t readily available in the form of a bank account linked to a card in your wallet, it makes it much harder to avoid dipping into that cash when you forget your future self. Having to complete a form and send it off, or log in to a website and enter the instruction, may give you that extra time you need to regain control of your consciousness.

Don’t let today’s low interest rates discourage you from building your emergency fund. It’s true that cash is not currently yielding much by way of interest rates; be content rather that you’re getting a real return.

Whatever you choose, you must make an effort to understand where you have parked your money. If it is a unit trust, download the fact sheet. It may seem confusing at first, but read it anyway. We’ll explain fact sheets later on and help you to make sense of them.

The Editors

 

[1] Some banks do however have their own money market unit trust fund.

[2] It is not impossible for a money market unit trust to have a value of less than R1.00 but this is highly, highly unlikely and generally not anything you should concern yourself with.

[3] There are a lot more options out there; this list is a mere sample.

[4] If you borrow more from the bank, your monthly instalment will go up, unless you extend the duration of your bond.

[5] Remember that “long term” does not mean forever.

People who Rock

Take Charge of Your Money TaxTim