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Aug 12 2008

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Your Cash Management Plan: The Emergency Fund

Your Cash Management Plan: The Emergency Fund

As a financial planner, I often observe when I meet prospective clients for the first time is their lack of an emergency fund as part of their cash management plan. Why do we need an emergency fund? At anytime, we could experience a situation where our cash flow cannot meet the demands due to an unexpected emergency. These range from the moderately inconvenient, like a major car repair, to the potentially disastrous, like the death or disability of an income earner, or a long period of unemployment. Some of these problems can be moderated by life or disability insurance, or by unemployment insurance, but some financial impact will likely remain.

Some form of emergency fund is crucial to every cash management plan. The size of fund that is right for you will depend upon your circumstances. Some questions to consider include:

· How secure is your job?

· If you lost your job, how difficult would it be for you to find a new one?

· Are you the sole breadwinner in the family?

· What would happen to your cash flow if you or your spouse died or became disabled?

· What is the condition of your car? Your furnace? Your major appliances?

· What would happen to your cash flow if one of your parents or children suddenly became ill, and you had to take a leave of absence from work?

From the Canadian Institute of Financial Planners, Practitioner’s Guide, the recommended emergency fund should be between four and six times monthly expenses. Remember it’s based upon expenses, not income! So how is it calculated? Add up the following expenses.

· Shelter

· Household and Family

· Transportation

· Discretionary

· Other Debt Repayments

If we assume total monthly expenses of $2,000, then the emergency fund range should be between $8,000 and $12,000. While this may seem like an insurmountable challenge, it can be implemented over several years and can begin with as little as $25 per month.

You don’t have to keep emergency funds sitting in a cash account, and in fact, this is not recommended as if it’s too accessible, you might be tempted to spend it! Some of the more traditional possibilities for emergency funds include money market mutual funds, high yield savings accounts, Canada Savings Bonds, or T-bills. It may also be possible to restructure some of your existing assets so that they can be accessed in an emergency.

In a pinch, you might withdraw funds from the RRSP. This might be appropriate during a long period of unemployment when taxable income is reduced anyway. But be forewarned, the contribution room cannot be restored at a later date. While overdraft protection or a personal line of credit might be considered, I would generally warn against it. With borrowed money, principal plus interest must be repaid and what happens if you get into serious financial difficulty, such as job loss where the emergency lasts longer than expected.

 

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