Emergency fund
An emergency fund is an account that is used to set aside funds to be used in an emergency, such as the loss of a job, an illness or a major unexpected expense. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to use high interest debt, such as credit cards, as a last resort.[1] An emergency fund can increase your peace of mind[2] and feeling of control.
The 2019 Canadian Financial Capability Survey shows that about two thirds of Canadians have an emergency fund sufficient to cover 3 months’ worth of expenses.[3] While that seems encouraging, the figure is only 54% among Canadians aged 55 or younger.[3] That leaves almost half of people 55 years old or less for which if an urgent and unexpected expense occurs, they may either have to go into debt, or sell longer term investments, perhaps at an inopportune time.
A general rule-of-thumb is that an an emergency fund should contain enough to cover three to six months living expenses.[2][4][5] People with unstable jobs might feel safer with 9 or 12 months of expenses saved up. The Ontario Securities Commission offers an Emergency Fund Calculator.
This article is focussed on emergency funds for people of working age. For retirees, the emergency fund often morphs into a contingency fund during retirement, which has special considerations and is treated in a different article.
This article first looks at what assets to hold in your emergency fund -- typically cash -- and then at where to hold them -- e.g., in a registered account or not. The article then discusses exclusions and triage, and offers a few tips on how to accumulate your emergency fund.
What assets to hold
An emergency fund is aptly named because its purpose is to provide a source of cash when the unexpected happens.
An emergency fund should be in a placed in a highly liquid, low risk vehicle - a cash or cash-equivalent account. A typical choice is a savings account at a bank or online bank, such as a high-interest savings account (HISA).
For urgently needed cash, e.g. to pay for car problems or home repairs, you may also want to keep a certain balance in an instantly available account like a chequing or saving account. This offers ATM access, the option of making interac transfers, or paying with a debit card, unlike with some HISAs. However, partly for psychological reasons, most of the emergency money should probably be in a separate account (e.g., a HISA) to remove the temptation to spend it.[4]
For needs longer than a few months, such as a period of unemployment, either a HISA or cashable Guaranteed Investment Certificates would be appropriate.
Equities should not be used for emergency savings (or any targeted savings) because of the risk of an equity decline. Long maturity bonds are also volatile and not a good option for emergency savings.
Some people consider a line of credit (LOC) to be an emergency fund. However, a LOC has to be paid back with interest, and also runs the risk of being withdrawn by the lender. A true emergency fund has no payback or interest obligation.
Registered or non-registered?
An emergency fund, for example as a HISA, and can be held in a Tax-Free Savings Account (TFSA), which will make interest payments tax-free. However, with currently low interest rates, the tax savings will not be substantial, and it might be a better idea to keep the emergency fund unregistered. Instead, TFSA space can be utilized for investments with a higher expected return, such as equities, as part of retirement savings.
A Registered Retirement Savings Plan (RRSP) account would not be a suitable place for an emergency fund, because the RRSP is meant for retirement savings, and because income taxes would be due upon making a withdrawal.
Exclusions & triage
Emergency funds should not be used to pay for discretionary purchases such as vacations or other major, planned expenses. These planned discretionary expenses can be paid for using distinct savings accounts (e.g., the "vacation fund"). The intent of the emergency fund is to cover necessary expenses such as groceries, rent, or utilities in case you loose your job, are incapacitated, etc.
In the event of a financial emergency, spending discipline may require forgoing certain "normal" expenses such as dining out or entertainment. By avoiding spending on these types of items, emergency funds may be stretched to cover longer periods of time or additional emergencies before being replenished.
How to accumulate an emergency fund
If you are having difficulties saving up for your emergency fund, you could set up an automated periodic transfer from your chequing account to a savings account.[2] Another trick is to save any sudden cash inflow, such as a tax refund, bonus, cash gift, etc.[2]
In general, attaining any savings goals might be easier with a budgeting approach.
Does everybody need one?
There are some scenarios where a stand-alone all-cash emergency fund may not be needed. For example, retireees who have a significant cash allocation in their portfolios may have enough liquid reserves to face emergencies.
Another scenario is a wealthy (high net worth) and risk-tolerant household; such a household may prefer to hold a single portfolio (without a separate cash-only emergency fund) as part of "an aggressive strategy of minimizing cash reserves and maximizing account holdings".[6] The tradedoff is loosing the psychological benefit of the cash reserve.
See also
- Budgeting
- Short term cash returns
- Money market funds
- Disability insurance
- Contingency fund during retirement
References
- ^ Investopedia, Emergency fund definition, viewed June 15, 2012.
- ^ a b c d Financial Consumer Agency of Canada, Setting up an emergency fund, viewed October 17, 2021.
- ^ a b Financial Consumer Agency of Canada, Canadians and their Money: Key Findings from the 2019 Canadian Financial Capability Survey
- ^ a b Ontario Securities Commission, Plan for emergencies, viewed July 3, 2019
- ^ Lee ST, Hanna SD (2021) What, Me Worry? Financial Knowledge Overconfidence and the Perception of Emergency Fund Needs. Accepted for publication in the Journal of Financial Counseling and Planning, available at SSRN, viewed October 17, 2021.
- ^ Scott J, Williams D, Gilliam G, Sybrowsky JP (2013) Is an All Cash Emergency Fund Strategy Appropriate for All Investors?, Journal of Financial Planning, September 2013, viewed October 17, 2021.
Further reading
- Financial Wisdom Forum topic: "HELOC versus emergency cash" for a discussion of the pros/cons of using a HELOC as your emergency fund.
- Financial Wisdom Forum topic: "What does "Emergency Fund" mean to you?"
- Financial Wisdom Forum topic: "finiki: Emergency fund"
- Financial Wisdom Forum topic: "Canadians have no emergency fund"
External links
- Average Emergency Savings Fund up 18 per cent From 2014; One Quarter Living Paycheque to Paycheque: BMO Rainy Day Survey
- Morningstar video with Christine Benz: The Importance of an Emergency Fund, 2020
