In the sci-fi classic Ender’s Game, gifted children play simulated battle games with aliens at the edge of the universe, until (spoiler alert) the title character realizes during an especially intense sequence that he’s in the midst of the real thing, and everything to that point has just been practice.
When clients last contemplated their emergency funds, a global pandemic would have been well at the perimeter of possibilities. And yet, here we are.
So, those with an emergency fund may now be asking: How do I use it? And those who don’t have one — but are fortunate enough to still be in regular earning mode — should be thinking about how and when they would use an emergency fund as they begin saving.
Regular budgeting addresses recurring expenses, plus reserves for periodic capital outlays. Insurance is for the extreme where there are remote-risk/high-peril events. An emergency fund lies between.
The fund allows a client to sustain their household in a time of crisis — whether that’s an unexpected injury, job loss or a global pandemic — while expenses continue to pile up.
How and when they should use the emergency fund is a function of how they define “emergency.” Encourage clients to commit to the above definition when they begin saving so it’s preserved for truly pressing needs — like now— and not depleted on emotional wants.
Using an emergency fund
Like Ender’s alien battle, we’re no longer practising. It’s time for clients to actively monitor and log their spending. This will help them manage the current situation, and learn for future planning. This is how clients should use their emergency funds now:
- The immediate non-negotiable needs are food and safety. Clients can cut down on these expenses by shopping brand-consciously, reducing cost-per-unit by buying in (reasonable) volume, and being vigilant about portioning and waste.
- Shelter costs like rent/mortgage and utilities are next. Federal government income supports should help indirectly, and housing-specific relief may be on its way, whether from government, lenders, landlords or a combination. Whatever form and amount this takes, clients must understand why this is a top priority: interest and penalties on short/skipped payments will compound the emotional and money stress the very next month, and further impair a client’s finances in the recovery time to follow.
- Dispensing with all discretionaries may not be practical as clients hunker down for the coming days and weeks, but they should be selective about the prudent pleasures they choose.
- Suspend luxuries and harbour no regrets. Encourage clients to keep their focus on the present, comforted that their conscientious actions today will improve their prospects tomorrow.
- Counsel clients to log where their money is coming from and where it’s going, so they can manage within their changing means. That’s a good habit in good times, and critical in a crisis. Many have a bit more time these days to form the habit.
Building a fund for future crises
The emergency fund’s purpose, now or after the Covid-19 crisis, is to have money accessible for a specific number of months. But how many? Clients should start by planning for the most likely emergency: an employment gap.
Based on the client’s industry and where they work, how long do they think it would take to get re-situated? An estimate provides a goal for the number of months of funding.
Second, while losing income is painful, what matters most in an emergency is spending. Help clients review their bank and credit statements from the last year, taking out anything truly extraordinary and deducting items they may be able to defer for a few months. Divide the total by 12 for a monthly average, and multiply by the chosen number of months. This is the client’s lower limit (the upper limit includes those deferred items).
Third, set up a regular deposit to the fund, ideally aligned with the pay cycle. Clients should assign a percentage or dollar amount they can commit to, even if it’s a small figure.
Now, the gut check: divide the emergency fund target by the weekly deposit commitment. This will show how long your client needs to get there. If they feel a knot forming in their abdomen, they may want to bump their commitment. But that unease must be balanced against the discomfort from the current budgetary sacrifice in order to arrive at a manageable medium.
As a kicker, an oft-suggested alternative to an emergency fund is a line of credit at the ready with a bank or credit union. For some people, taking on debt at a time of financial stress may be an uncomfortable proposition. Still, establishing a line of credit can be an effective complement to an emergency fund, knowing that it will be there to fill the gap if an emergency hits before the fund reaches its accumulation target.
Registered or non-registered?
Your RRSP is not an appropriate choice as an emergency fund. With withholding tax as much as 30%, clients will have to take a higher gross amount to net to what they need. And if the withholding is less than the actual tax due, they’ll be scrambling to come up with cash at filing time next year. Withdrawing from an RRSP for an emergency also puts retirement at risk. Keep these two needs separated.
On the other hand, the TFSA is well suited for emergency needs. With no tax to deplete withdrawals, budgeting is much more transparent. Withdrawals are also entitled to the usual re-contribution credit, which can be both the motivation and target for replenishment once the emergency passes.
Doug Carroll is tax and estate counsel to Aviso Wealth in Toronto.