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Session 24: Life Goal 1 - Planning for Contingencies

We are glad to have you with us for our twenty-fourth session - (let's talk about the) 1st Life Goal - (which is) Planning for Contingencies

Alright, so now let's get started...

Prudent Planning is the first step in achieving any objective in life. Planning not only makes your job easy, but also gives you a sense of direction to achieve your objective. However you have to adopt prudence while planning and more so when you are dealing with your finances.

Planning for your contingency fund is an important aspect for a smooth financial journey.

So in this session we'll explain the first and most important step in financial planning i.e. Planning for Contingencies.

First let's understand...

What is Contingency Planning?
  • (It is...) Planning for rainy days

  • (By...) Keeping aside money for any unknown and uncertain event (...that may occur but is not likely or intended, such as medical emergencies, loss of job or any other eventuality for which you haven't planned for)

  • (If not taken care of...) Such events may derail one's finances and lead to a financial crisis (...and hence you need to plan well in advance)

  • (Planning and providing for such unforeseen events in advance means... you are in the...) Process of building a Contingency Reserve

Such a contingency reserve may help you tide over unexpected situations that may drain your finances and may not be covered under any other means.

Now you may ask...

How much Contingency Reserve should be maintained?

Minimum: 6 months of expenses
Maximum: 24 months of expenses
[Maintain a sufficient amount in your contingency reserve]

Well, you should maintain a minimum of 6 months of expenses as contingency reserve and a maximum of 24 months. This will enable you to cover expenses in case a contingent event does occur. So while keeping money aside as a contingency reserve, you ought to prudently ascertain your expenses, for contingency planning to be effective. This is because if you under-allocate, you are not being effective in such a contingency planning exercise.

You see, maintaining less than 6 months will mean that you do not have a sufficient amount to deal with emergencies and maintaining more than 2 years will mean that you have extra cash, on which you are losing out on investment opportunities. Thus you should always maintain a reasonable amount of contingency reserve by accounting for your expenses wisely.

What kind of expenses should be covered in Contingency Planning?

While creating a contingency reserve you should take into account all such expenses that are rather unavoidable. You can consider your...

  • Household Expenses (...which are towards your basic needs and utilities)

  • Lifestyle Expenses (...where you may control a few of such expenses)

  • Medical Expenses ( they are unavoidable)

  • Travel Expenses

  • EMI on loans (...where you should remember that it is not advisable to default on your loans)

  • Children Education Expenses (...which are a priority)

  • (And...) Any other Unavoidable Expenses

You see, of these expenses some are unavoidable expenses which are to be paid even if there is loss of income, or no income.

Let's take an example to understand better...

Contingency Planning: Example 1

Mr Shah is a government employee and has a very stable career. His monthly expenses are:

Household = Rs 25,000;

Lifestyle = Rs 10,000;

Medical = Rs 5,000;

Children School Fees = Rs 2,500;

EMI = Rs 12,500.

(So here let's understand...) How many months of contingency reserve should he maintain and what should be the amount of his contingency reserve?

Mr Shah should maintain:

At least 6 Months of Contingency Reserve
Amount of Contingency Reserve = Rs 3,30,000 (i.e. 6 months x Total Monthly Expense of Rs 55,000)

(The name and figures used in this example are for illustration purpose only)

Since Mr Shah has a very stable career and his job is quite secured being a government employee. 6 months of contingency reserve should be sufficient to take care of his emergencies. Thus as a multiplication of the expenses which he is incurring, the amount of his contingency reserve will be Rs 3,30,000.

Now let's take an example of another individual Mr Tiwari...

Contingency Planning: Example 2

Mr Tiwari is an IT consultant and his career is highly dependent on India's economy. In a booming economy his income doubles while in a weak economy, it is vulnerable. His monthly expenses are:

Household = Rs 10,000;

Lifestyle = Rs 5,000;

Medical = Rs 15,000; and

Travel = Rs 10,000

(So here let's understand...) How many months of contingency reserve should he maintain and what should be the amount of his contingency reserve?

Mr Tiwari should maintain:

2 Years of Contingency Reserve
Amount of Contingency Reserve = Rs 9,60,000 (i.e. 24 months x Total Monthly Expense of Rs 40,000)

(The name and figures used in this example are for illustration purpose only)

Since Mr Tiwari's income is highly uncertain and can also lead to low income in the case of a weak economy, he requires to maintain 24 months of contingency reserve. Thus as a multiplication of the expenses which he is incurring, the amount of his contingency reserve will be Rs 9,60,000.

Options to maintain your Contingency Reserve

Contingency funds are meant for emergencies. So returns are secondary, and therefore one should make a sensible decision while building a contingency reserve. You see, in case of any urgency, money should be available for use within 24 to 48 hours. Accordingly there are various options which you may consider for keeping money aside, for your contingency needs. Some of the prominent options are...

  • Cash in Bank (...You can maintain a small portion of your contingency reserve in a savings bank account for liquidity, which can be accessed any time. But as it is next to having some money in your wallet, it may hardly earn for you. Do not forget, the longer the money lies idle, the more is the loss in value. Hence you can limit the amount of contingency money kept in your savings account.)

  • Bank Fixed Deposit

  • Sweep in Account

  • Flexi Deposit

    (For a safe and better return, you can keep some money in a bank fixed deposit or sweep in account or have a flexi deposit with your bank. If possible, you should link it to your savings bank account to withdraw it in an emergency. But withdrawing such money prematurely may attract penalty, or in some cases you may even lose a portion of your interest earned, based on your bank's policies.)

  • Money Market Mutual Funds (...As many people fear losing money, they do not invest, or invest such contingency money only in options like FDs which can attract penalty on premature withdrawals. Many people in India are still unaware of various investment options suitable for very short term investments like: liquid and money market funds, which have the potential to earn returns more than interest on a savings bank account.)

Let us now dwell a little deeper and understand - How you can maintain your contingency reserve through mutual funds...

Maintaining your Contingency Reserve through Mutual Funds

While mutual funds offer you various investment options targeted towards various investment objectives, there are some categories of mutual funds that invest in instruments of very short duration and are suitable for maintaining one's contingency reserve...

  • Liquid or Money Market Funds (...These funds can be considered in order to park a portion of one's contingency fund with a shorter time horizon of less than 90 days. As most liquid funds do not have any exit load, one can exit any day, without any penalty. On withdrawal, the redemption proceeds are usually credited to your bank account within 1-10 days.)

  • Liquid Plus or Ultra Short Term Debt Funds (...These are funds that invest in instruments with higher durations as compared to the liquid funds. As the duration is slightly higher, the risk is slightly higher as well; but they have the potential to yield returns higher than those clocked by liquid funds. While most of these funds do not carry exit load, there are some ultra-short term debt funds that have an exit load period of 7 to 30 days. Hence the money that may not be required within 3 to 6 months can be kept in these funds.)

  • Floating Rate Funds (...They aim to generate returns in line with the prevailing interest rates and are suitable to hedge your corpus against interest rate risk. While these funds carry less interest rate risk, they are meant for investments with a time horizon of around 6 to 12 months.)

  • Short Term Debt Funds (...There may be times when you may not be using a portion of your money for long, say the next 12 to 24 months. Money meant to take care of your medical emergencies etc., can be kept aside for a slightly longer duration. Short Term Debt funds invest in instruments with duration of around 1 to 2 years and hence can be considered where the investment horizon is of around 1 to 2 years. Do not forget, many short term debt funds may attract an exit load if withdrawn within 6 to 12 months. So you need to plan accordingly.)

Points to Remember...

  • Contingency Reserve helps you pay for unexpected expenses

  • (So...) Create a Contingency Reserve for a minimum 6 months of expenses and up to 24 months of your expenses (...based on the level of your income)

  • (As...) Contingency funds are primarily meant for emergencies, the returns should be secondary ( should make a sensible decision while maintaining your contingency reserve)

  • (It would be prudent to...) Diversify your contingency funds across suitable options

  • Planning for contingencies should be considered as an important life goal

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Disclaimer: The contents of this document are only for informative purposes and are not to be used or considered to be an offer to sell or buy units of Franklin Templeton Mutual Fund schemes. This video is for information purposes only, provided on an 'as is' basis. Nothing in it should be construed as personal financial advice. You are responsible for your own investment decisions and you should seek advice concerning suitability from your investment adviser regarding any of the investments mentioned. The video is for personal non-commercial use only and may not be copied, stored, redistributed or broadcast in any way. We recommend you read the complete Terms of Use.

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The Retirement Planning Guide

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