Financial Planning for Contingencies
Many a time, things don’t pan out according to your plans. It makes sense then, to have a contingency plan armouring you to deal with unexpected outcomes. A contingency plan is often used to manage risk that may seem unlikely to happen, but if it does, would have a disruptive impact on your life.
For example, a sudden job loss can derail your financial planning but most importantly, also leave you struggling to meet your everyday expenses and financial obligations like a personal or home loan till you find another job. Having a contingency fund will ensure that you don’t have to worry if such a situation arises. It will enable you to pay your EMIs on time, even if your cash flow stops for some time as you have anticipated this and kept funds aside.
Hence it becomes important to plan for such unforeseen contingencies. This is why you must keep aside some funds as a contingency or emergency fund.
Contingency Planning Challenges
There are two behavourial tendencies that usually act as obstacles when you start your contingency planning.
Inability to go beyond plan A. When you plan anything, it requires a considerable amount of emotional investment and not just a financial one. There is a fair chance that you might get emotionally attached to your goals and the planning behind it, so much so that you don’t think of an alternative plan – Plan B. A wise investor always thinks through an alternative plan with the same detail and keeps a plan B ready, if needed.
Low priority. Many of us don’t plan for crisis until it actually happens. Since the probability of a contingency is often low, it never seems an urgent task, until it’s too late.
Why create a Contingency Fund?
A contingency fund takes care of your day-to-day financial requirements in case of any financial emergency like a job loss, medical expense or any unfortunate situation or event that results in temporary financial loss.
Take a Quiz
Consider the following example: Vivek requires ₹50,000 to meet his monthly financial needs:
||Monthly expense (₹)
|Son’s tuition fee
|Personal loan EMI
|Money he sends to his parents
|Total monthly expenditure
It will be a wise decision for Vivek to keep aside some funds for his necessary monthly expense as a contingency fund. Since this is kept for an emergency, he needs to invest it in a product that is fairly liquid. Now how does Vivek determine how much money he should keep aside as a contingency fund? Ideally it should be atleast 6 months of his essential monthly requirements. This can be extended to a year to be on the safer side.
Calculating one's Contingency Fund requirement
In the above example, Vivek needs to save and keep atleast ₹3 lakh (₹50,000 X 6 months) in his contingency fund to ensure that he can fulfil his financial obligations for the next 6 months, if a situation arises.
|Monthly living expenses
|₹50,000 x 6 months
|₹300,000 / 12
He can put aside ₹ 25,000 every month for a year to build his contingency fund. Also, rather than letting this money lie idle in a savings bank account, he can opt for a flexi-deposit or a liquid mutual fund. Liquid funds have no entry or exit load and also provide higher returns than bank deposits.
Knowing that you have a contingency fund will certainly give you the confidence of keeping your investments and financial planning on track, even if your regular cash flow stops or lowers temporarily.