Our typical understanding of an emergency fund is one that is untouchable and typically yields close to no returns because we need to keep it easily accessible. Typically, most people keep 6 months of expenses as their emergency funds.
In my view though, I prefer 6 months of income as my emergency fund. I believe my conservative approach is justified especially during a crisis like COVID19. If you are in the airlines/events/nightlife industry, 6 months of income may or may not be enough. I'm pretty certain anyone with only 6 months of expenses in these industries would be desperately looking for additional work to offset bills and expenses.
Here's the contention, to set aside so much money as free cash flow without making it work harder seems very expensive in view of inflation. I don't disagree.
Hence, I'd like to explore this idea of keeping aside 6 months of expenses as a real emergency fund while setting up a secondary 6 months income emergency fund that can generate some returns while staying idle but can easily be utilized if the need calls for it.
Concept of emergency funds
For starters, emergency funds generally needs to be accessible at a time of need without penalties. That's why, I'd still encourage a 6 months expense fund that is left idle either in a bank account or fixed deposit.
Next emergency funds are not your usual spare savings you use to cover your bills when you overspend on your expenses. It's a fund that you would not touch under any circumstance unless something as unexpected as COVID19 happened and you need this additional funds to tie you over till situations improve.
How to structure a useful emergency fund?
For an emergency fund to also be useful, it needs to generate a certain return that can potentially measure up with inflation. The capital also needs to be guaranteed, if not it defeats the purpose of it being an emergency fund. So this eliminates investments as a potential vehicle to park the money. Lastly, the capital needs to be able to be withdrawn without penalties. If you would be penalized, then you would be losing money which defeats the purpose of an emergency fund again.
However, it is probably pretty well known that most better yielding instruments have a lock in period and typically most instruments are long term. Which is true. That's why this emergency fund idea I have is designed to be built over time.
How Annuities Work?
The simple mechanics of annuities usually starts with either a lump sum or yearly contributions (can be monthly, quarterly and semi-annual), payout can start either after the contributions end or after a waiting period and the payout is yearly for life. The principal will be guaranteed usually after the accumulation period ends or for some other plans there's a breakeven so you essentially have liquid cash with life-time payout once your commitment period stops.
How can annuities serve as a useful emergency fund?
As the contribution period for annuities can be pretty short (can even be a single lump sum), most people are very comfortable to set aside some money to build a secondary emergency fund that can cater for larger emergencies. Most of the time, this can be achieved over a period as short as 5 years (the shortest period the capital of annuities can become guaranteed on paper at the time of this article). Given that the fund is only accessible after a period of time, I'd suggest planning for a future emergency fund amount (eg expected 6 months income 5 years later) instead of a current one as the figure might not be so relevant in the future.
As annuities secures the capital after the predetermined period, it means that anytime after that period, the funds can be withdrawn without penalties. Naturally, taking up a commitment should come with some benefits. Annuity plans typically provide an income for a lifetime after the accumulation period and that can potentially beat inflation.
So why is it worth considering as a way to potentially build a useful emergency fund?
There are certain features of such plans which I really find attractive.
One would be the short commitment period. We won't want to be constantly building an emergency fund and neglect other aspects of our bigger wealth accumulation needs like retirement planning.
The other would be the short breakeven period. It's no point having a solution that you finish saving quickly but can't draw out the funds within a reasonably short time frame. Then it will be called a retirement fund not an emergency fund.
The perpetual income payout which can help to defray some ongoing cost while the funds are not in use. Emergency funds as defined earlier may possibly remain unused for a lifetime. It's there as a safety net in case an unforeseen emergency happens that our other funds can't cater for. Hence if it remains in a savings account, the opportunity cost would be beating inflation. The bigger the pool of funds set aside as emergency would mean a bigger opportunity cost. A yearly income payout after the accumulation period would thus go a long way in making these funds useful. Such payout can be as useful as paying for our rising hospitalisation insurance premiums or one of our term plans. Some people might use the income to pay for holidays or simply accumulate it to ensure their emergency funds stay relevant.
Potential pitfalls when using this approach
Naturally anything that gives you a better option also has it's own drawbacks. Here are the few important ones you need to look out for.
All annuity plans have an accumulation period. In other words, you cannot put in money today and take out tomorrow without penalties. That is not possible. Hence, your 6 months expenses emergency funds should still be sitting in your bank account as your first line of defense.
Withdrawal of your annuity funds even after breaking even is not immediate. There's processing time typically at least 1 week. You can't draw out money like an ATM.
Annuity plan is still an endowment so once committed, you need to see it through. Unlike a standard savings where you can be undisciplined, once you decide to set aside $x a year for x years, you need to do so.
Since we are on this topic of endowments, the income you get has a guaranteed and non guaranteed portion. However, if it's taken up with the intention of being a secondary emergency fund, I think the opportunity cost of a lower return is not such a big issue because the alternative of deposit accounts is likely to be less favourable.
Summary
In a nutshell, an annuity plan is an interesting solution to consider as a secondary emergency fund where you set aside a more feasible amount to shoulder bigger emergencies. However, it cannot be your primary emergency fund because of the way it works. I'd like to consider it a sufficiently short term solution that offers liquidity within a reasonably short period that can potentially meet inflation.
If you would like to explore using annuities to build up your secondary emergency fund, please speak with a trusted advisor. You can also drop me a message if you would like me to help you with it.
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Disclaimer: The content created are based on my personal opinions and may not be representative to everyone or any organisation. If you have any doubts or queries pertaining to insurance or investment, please seek professional advice from a trusted adviser in an official setting. You may also reach out to me if you do not have a present adviser using the message box under 'Let's Talk'.
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