Time to open an emergency account

It’s something every advisor knows and hopefully puts into practice: get your clients to establish an emergency bank account.

From the 1970s through to the 1990s, this was a no-brainer, as interest rates were relatively good on the usual savings vehicles — high-interest savings accounts and Canada Savings Bonds. But in the last decade or so, interest rates have dropped to record lows, credit has become more easily available, and clients and advisors have started expecting portfolio returns significantly higher than an emergency fund would generate.

So it’s understandable that the emergency account would disappear from a lot of investors’ lives. But, forgetting about the rainy-day fund meant that clients and advisors were neglecting the fundamentals of financial planning.

In the current economic climate, credit has been tougher to obtain and unemployment rates are rising rapidly; EI pays very little compared to many people’s spend-what-you-earn lifestyle, and using a home equity line of credit in a period of declining real estate values is neither wise nor likely possible. Thanks to all that, an emergency fund is an absolute must in these economic times.

The main reasons for creating an emergency fund for clients are to protect them in the event of a layoff; to provide cash in the event of a sudden disability or illness requiring time off work; and to provide funds for any other possible emergency (e.g. a new roof for the home, a new furnace, car repairs).

The biggest con against an account like this is that most advisors would suggest that a client pay down non tax-deductible debt first. While paying off and cancelling credit cards is still a critical step to financial security, so too is having extra money in case of an emergency. So doing both is critical, even if the savings are small to start with.

What’s in a fund?

Creating an emergency fund does not mean investing aggressively in an equity portfolio and selling when the going gets good — the money needs to be safe and secure, preferably with a CDIC-insured institution. It should also be liquid, so that the client can get easy access to her cash if need be, but it shouldn’t be so accessible that it can be frittered away.

Canada Savings Bonds meet these criteria, as they are liquid, but not so liquid that they can be spent inadvertently; they can be purchased by payroll deduction, which makes them a great "Pay Yourself First" savings vehicle, and interest paid on purchase can be deducted as an interest expense. They can be useful for clients who have great difficulty saving once they get their hands on their paycheque — by the savings coming off at the source and the ability to buy in small denominations, non-savers can actually save! The downside is that the interest rates are abysmally low.

Saving grace

While this account won’t be the one clients use to save up for that expensive house on the beach, the more they can save the better. Still, make sure clients know that the fund isn’t designed to provide money for non-essentials such as entertainment, vacations, gifts or eating out. It is designed to ensure that clients can maintain a roof over their heads, put food on the table and maintain payments for essentials.

Figuring out how much clients need to save requires answers to a few questions, as the amount of savings depends to a large extent on individual situations. What is their level of debt? Do they have dependents? Is their spouse employed at the same company? Is their occupation one for which there is usually a demand, so any period of unemployment is likely to be short term? Or will they be faced with the possibility of retraining in another field, which will mean substantial time and financial costs? Do clients have other investments of a sufficient amount that they could access if need be? Do they have family who would be likely to help out? The general rule is that clients should have at least three to six months of living expenses in their emergency fund. Clients in real danger of job loss in this economic climate should be saving and building their emergency funds as rapidly as possible.

Goodbye taxman

Until the advent of the tax-free savings account (TFSA) this year, the amounts saved in these rainy-day funds always generated interest that is fully taxable. Clients were often incensed about this and preferred to put their money into mutual funds, where the returns were better and often the tax treatment was preferential. The TFSA provides a great savings vehicle for an emergency fund, and by encouraging clients to save this way, they will automatically build a solid emergency fund — and there will be no tax on the interest! With a couple both building savings of $5,000 each in a TFSA, there will be a solid basis of an emergency fund right there. For clients and advisors who feel the RRSP is more important, taking the tax refund generated by the RRSP contribution and putting it into the TFSA allows accumulation of assets that are all tax sheltered.

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(02/10/09)