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03 June, 2012
Providing for emergency/ liquidity
Liquidity management is one of the most neglected areas of one’s finances. Most people tend to think that liquidity management stops at maintaining a sufficient cash balance in one’s savings account. Some maintain fair amount of actual cash itself.
Both of the above may not be the best way to maintain one’s liquidity. We need to maintain liquidity to take care of the current expenses. Also, a margin of safety needs to be maintained. For that purpose, a liquidity margin is to be maintained, which would typically cover three to six months expenses. Three months expense cover is good enough for most people. Six months cover is suggested when the earnings outlook is uncertain. Also, it is suggested when incomes fluctuate, due to the nature of their job itself ( say a TV artist or someone in a sales function where the commissions fluctuate ). For some, even the expenses can be variable on a monthly basis. A higher liquidity margin will provide the additional cushion, in such cases. Also in cases where there is a loan and an EMI is being paid, a higher liquidity margin is critical.
Liquidity can be maintained in one’s bank account to the extent of what one may reasonably require for expenses, plus some. Since savings bank account offers 4-5% pa interest pretax, it is not the most desirable of places to park one’s money, beyond the absolutely necessary level. Since, the liquidity margin may not be touched for the most part, we need to invest in a place which can offer better returns than a savings account. One of the places where such funds for liquidity can be maintained are sweep-in deposits, which are available in a bank. These offer far higher returns as compared to savings bank account. These deposits get created when there is more than a certain amount of money in one’s savings account. For all practical purposes, the amount in flexi deposit is like the money in the savings account, as they are available for withdrawal anytime, as an when required.
The other desirable place to park the liquidity amount is in ultra short-term funds. These funds offer good returns of over 9%pa. What’s more, the tax treatment here can be far more benign… if invested in the dividend option ( which would be the correct choice ), the dividend distribution tax is at 13.5%. For a person in the highest tax slab, this will translate into major savings. Ultra Short-term funds do not have exit loads or have for very short periods. Hence, when required, they can be cashed out and used.
We would also be planning for events which are going to come up – like an upcoming premium payment, holiday funding, annual school fee payment etc. To meet them without problems, we would have to create provisions for these events which more or less are certain. The other situation for which we need to plan for is a contingency. Contingency is an event which can happen, but the timing is uncertain. An example of contingency is a medical emergency. Or it could be a financial emergency of a dear one, which needs to be met.
In both these cases, we have a variety of instruments to contend with. Since the tenure is known in case of provisions, we can invest in an appropriate instrument. For instance, if an expense of Rs.50,000/- is coming up 4 months hence, one can invest in a monthly interval plan and roll it over till it is required. If an expense is coming up in about 3 months, a quarterly interval plan ( QIP) would be more appropriate. At current rates, even an ultra short-term fund would be a good bet. For somewhat longer tenures – say one year – a Fixed Maturity Plan ( FMP) of a similar tenure would do the job. If the timing is rather uncertain, one can invest in a QIP and roll it over, till it is required.
For contingencies, the timing is uncertain. Hence, investing in somewhat longer tenures is actually desirable. Many instruments present themselves for this. However, care needs to be taken that these are not invested in locked-in instruments, which cannot be easily liquidated ( eg. FMP ), when required. Also, only a small portion should be invested in instruments whose value can fluctuate like equity, as, if they cannot be liquidated when necessary as one may incur a loss, it beats the very purpose of a contingency fund. However, a contingency fund may remain unused for years on end. Due to this, investing a small portion into instruments which can potentially give good returns in the long-term is a good idea. One should restrict the investments to 20% of the portfolio.
Bulk of the investments can be in instruments which give stable returns and which can be liquidated. The instruments which lend themselves well for such investments are debt funds from the MF stable & FDs. Debt funds from Mutual funds that are chosen for this purpose can be short to medium term funds. Dynamic bond funds, Short term funds & medium term funds ( with average maturities of between 1.5 – 4 years ) can be looked at. FDs from banks are more suitable for contingency funds as liquidating them and getting the money into their bank account may be far simpler than if it were a company FD.
In sum, though investing for goals & other objectives are important in one’s financial plan, liquidity margin, provisioning & contingency funding are very important too. By investing in the appropriate instruments, one will be able to build a cushion as well as earn reasonable returns from such funds too.