Contingency means an unseen future event. A contingency fund is a reserve fund which is built and kept aside to take care of unexpected expenses or an unforeseen event. It can also be referred to as a fund which is liquid and easily accessible for an emergency purpose. A contingency/emergency can be a medical emergency due to sudden illness, accident or a financial emergency due to loss of job or losses from business
Usually, people understand the importance of contingency planning only after experiencing an unfortunate contingency event.
NEED
The need for a contingency fund arises after doing a complete and a detailed analysis of the risk associated with the life of the bread winner and his/her family dependents. Creation of a contingency fund is a must if there is only one earning member in the family.
However, even if both the husband and wife are working, a contingency fund is recommended. It is generally seen that those without a contingency fund are more likely to fall into debt traps than those who have a provision for the same. This is because those who do not have an emergency provision are likely to borrow money and don’t mind paying high interest rates considering the emergency situation.
Further, an emergency fund will mean a softer impact on monthly savings and you need not revise your entire financial plan if such situations occur.
HOW MUCH
There is no definite consensus on how much should be set aside for contingency. However, it depends upon the insurance and medical cover that you have and also the number of dependents.
To start with, you can have 2-3 months’ salary amount as a contingency reserve. A contingency reserve can also be built over a period of time if you don’t have the entire amount required in your bank account - the shortfall can be added on a monthly basis to the contingency fund.
WHERE TO PARK
Emergency funds need to have easy accessibility so they should be prudently parked in avenues that provide high liquidity. You can consider parking funds in savings account, even though they give low interest rates because they can be withdrawn at any time. Even with a debit card, one can easily access the money.
A part of the money can also be parked in fixed deposits. However, for those who are in the higher tax brackets of 20 per cent and 30 per cent, the returns from FDs post tax would be very low. Liquid funds can also be considered as an option for investment.
HOW TO MANAGE
Ideally, you should open a separate savings bank account in order to accumulate funds for contingency. However, to avert the temptation of spending money, experts suggest to not keep a debit card for this account. But debit cards are also useful during crisis as you can swipe the same instead of looking around for banks to withdraw money.
An emergency fund is a very useful tool, considering factors such as the volatile employment market and the changing lifestyle habits that tend to have an impact on the health of individuals. It is also always advisable to have sufficient risk cover for medical emergency and death of the bread winner.
(The author is CEO & Founder, Right Horizons)
