Money Management Case Study: Contingency Funds

By | March 6, 2015

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Ram prides himself on being up-to-speed in money management. Despite his hectic office schedule, he has managed to ensure health cover, life cover and investments spread across PPF, Mutual funds, and other instruments.

He met his friend Mr. Kent, who is a Certified Financial Planner. With a glint in his eyes, he placed his balance sheet in his friend’s hand and said, “Kent, how many marks will you give me for my financial planning acumen?”

Kent glanced at the same with interest and said, “Good, mate. You have done well and have most of the ingredients in the right place. I will give it 7 on 10.”

Why 7 on 10 and not 9 on 10

Kent explained, “To begin with, you don’t have a contingency fund.”

Ram protested, “I do have. See?” He pointed out the short term FDs in his balance sheet and his SB account statement.

Kent jabbed a finger at his friend’s SB account statement. “That’s a mistake,” explained the Financial Planner, a knowing smile playing on his lips. “See? You have 3 months of your expenses in SB Account. While having contingency amount of 3 months is a great thing to have, but keeping it in SB Account is virtually killing your returns – it can earn at least 50% extra in fact. In some cases, it could be double too.”

“But, what if I am in an emergency?” protested Ram.

Kent clarified: “If you submit your redemption within 2:00 p.m., your account will get credited within 10:00 a.m. the next working day. How fast is that”? As Ram sat wide-eyed, Kent continued, “In fact, one AMC even gives you an ATM card wherein you can withdraw your money in any Visa enabled ATMs across India!”

Stunned, Ram edged forward in his seat.

“What’s more,” Kent continued, “you can even use this ATM card like a normal ATM Card and do even your shopping!”

“See, Ram, you get your salary on the 1st of every month, but your expenses do not occur on the 1st, isn’t it? They are spread across the month. Your rent payment probably is on the 5th, school Fees probably fall on the 10th, your credit card or EMI is, say, on the 15th, and so on. So, instead of keeping your salary in SB Account, you can keep this money in Liquid Fund, withdraw as and when you want, and earn extra returns in the process.”

Safety, profitability and taxability of Liquid Funds

Not wanting to be seen as being naive, Ram managed feebly, “But, are they safe”? “Theoretically speaking, Liquid Funds do not guarantee or safety of principal; in fact, no Mutual Fund has the permission to do so. But Liquid Funds invest in Government treasury bills, money markets, short term corporate deposits and commercial papers and hence very liquid and safe. As all these instruments have very low risk, you can enjoy high liquidity. And, for your information, there is no Exit Load.”

Ram’s eyes lit up. “How much can I expect in returns?”

Kent smiled. “Now, you have come to the main point. Last year, on average, Liquid Funds have given 8% returns, and we can expect similar kind of returns this year. But, going forward, the returns may vary. How much does your bank give”? “4%. But, my other bank has promised 6%.”

“Yes, they will offer 6%, but they will probably have conditions like ‘minimum balance of above 1 lakh’, or other such limitations.”

“Yes, I know.”

Ram’s brows narrowed. “But, what about Taxes”?

Kent patted his friend’s shoulder. “Dividends declared by Liquid Funds are taxed at 28.33% in the hands of the investor. But, if you hold the fund for 3 years, then the same will be treated as Long Term Capital Gains and will taxed accordingly, but the advantage here is, you can claim the benefit of indexation. And, considering the inflation levels and the debt fund returns, the tax outgo could be only marginal.”

The takeaway

Prudent financial planning says that an investor should have some contingency fund to face any emergency in life. While Liquid Funds add an element of profitability and liquidity to your portfolio, the same cannot be said of SB accounts. Ram had parked his surplus in SB accounts and none in Liquid Funds – a classic case of putting all eggs in one basket.

As a financial planning best practice, always keep some cash at home for emergencies and divide the balance of your liquid surplus between SB Account and Liquid Funds depending on your requirements. This will ensure a good distribution of your Contingency Funds. I normally advise investors to keep 1/3rd of Contingency Funds in Liquid Funds. After all, 8% returns with 1-day liquidity is always superior to 4% returns in SB Account!

A final note

The recent hike in Dividend Distribution Tax to 28.3% (including cess & surcharge) may make many wonder if SB Account with up to Rs.10000/- in tax-free interest a better option.

I differ for the following reasons:

  • The average returns of Liquid Funds has always beaten SB Account interest by a minimum of 1%.
  • True, dividends on Liquid Funds are taxed at 28.3%, but the interest on SB interest is added to your overall income and is taxed as per your tax slabs.
  • The interest on Liquid Funds is paid on daily basis, whereas the interest on SB Account is paid on quarterly basis.
  • There are no charges by AMCs if the minimum balance in Liquid Funds goes below the prescribed minimum balance, whereas banks charge anywhere between Rs. 50 to Rs. 1000.

Caution: Do not use Liquid Funds for investment. Use them purely for parking your temporary surplus.

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2 thoughts on “Money Management Case Study: Contingency Funds

    1. Team BankBazaar

      Hi Kalyan,

      We’re glad you like it. For more on Personal Finance, do read our blog.
      Team BankBazaar


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