Discover the risks of using your Two-Pot Retirement Fund for emergency savings and learn how to create a robust financial plan that safeguards your future. File photo.
By: Keith Peter
Traditional financial advice recommends maintaining three months’ expenses in an emergency fund. However, inflation erodes the value of cash, making it challenging to keep pace with rising costs. Some South Africans have considered placing emergency savings in tax-deductible retirement fund vehicles, aiming for potentially higher returns, especially with the flexible access options provided by the new Two-Pot Retirement System (although retirement funds should only be used for retirement purposes).
This strategy is risky, I encourage South Africans to think carefully before using market-linked retirement funds for this purpose. During the Covid-19 pandemic, markets saw steep drops, leaving many who relied on their investments for emergencies withdrawing funds at a significant loss. This likely severely undermined the value of this money, causing many to go into debt at a time when they needed cash the most.
South Africans should rather manage inflation risk by starting with a holistic financial plan that considers emergency savings, retirement savings, as well as insurance. A realistic emergency fund should start with a holistic financial plan, which is a comprehensive strategy that considers all aspects of your financial health. This ensures that your emergency savings are aligned with your actual needs and priorities.
Adequate insurance—such as a vehicle, retrenchment, and income protection is important. Medical, or gap cover—can reduce the need to accumulate large cash reserves for emergencies, as specific risks are already covered. The plan should determine how much cash is required for emergencies and what risks are already mitigated through insurance, such as medical aid, gap cover, or vehicle cover.
For instance, if you already have gap cover for medical expenses, there’s no need to set aside additional funds for medical emergencies. It’s like paying for an additional external fitness class when an existing gym membership includes that class, by clarifying these details, you can avoid ‘over-saving’ in cash reserves that inflation could erode, while still being adequately prepared for unexpected events.
Only after these elements are accounted for should you select the most suitable savings vehicles, including whether to consider a tax-free option. Once you've assessed your financial risks, insurance, and tax obligations, and have the right insurance in place, choosing the right type of emergency savings account becomes easier.
There are a variety of savings vehicles available but stresses that a minimum requirement is a vehicle where the money is guaranteed, not linked to the stock market, and fairly easy to access.
Here is a checklist for building a smart emergency fund.
1. Set a realistic emergency fund goal based on actual expenses
Calculate an emergency fund amount based on essential expenses, tailored to your specific needs. Consulting with a financial adviser can help you create a customised safety net, ensuring your fund is neither too large nor too small.
2. Limit cash exposure with proper insurance coverage
Review your insurance coverage, including medical aid, vehicle insurance, and gap cover, to see what’s already protected. With adequate insurance, you can maintain a smaller cash reserve, knowing that major expenses are covered.
3. Choose stable and accessible savings vehicles
Once you understand your risks, select a savings vehicle that offers growth above inflation and quick and easy accessibility. Avoid volatile investments, such as equities, which may experience sharp drops and are less reliable for emergency needs.
4. Avoid keeping emergency cash in low-interest accounts
Holding cash in low-interest accounts, or “under the mattress,” leaves it vulnerable to inflation. Opt for a savings vehicle that balances growth with accessibility, protecting the purchasing power of your emergency funds.
5. Reassess your emergency fund regularly
Review your emergency fund periodically, especially if it hasn’t been used for some time, to ensure it’s still appropriately sized. If you find yourself with excess funds, consider reallocating some to higher-yield investments to keep up with inflation.
* Peter is an advice manager at Old Mutual Personal Finance.
PERSONAL FINANCE