Catherine Pope

Financial Coach & Workshop Facilitator

The Importance of Building an Emergency Fund

Photo of emergency money
Image courtesy of www.ccpixs.com

As a catastrophist, I’m very good at imagining all the things that could go wrong. Although this means I spend a lot of time worrying, it’s very handy for financial planning. More optimistic people (of whom I’m often envious) tend to assume that everything will be OK. Until it isn’t. Most disasters – such as ill health and unemployment – are completely unpredictable, so it’s important to build an emergency cash fund to protect yourself.

In my last post, I explained the risks of inflation on the value of cash. While this is a significant problem for long-term savings, you still need access to some emergency money. In this post, I’ll help you work out how much you might need and where you should keep it.

How much do I need in my emergency fund?

Well, this depends on your outgoings and what other forms of support are available to you. Hopefully, you’ve read my post on stealth expenses, so have set aside some money for large and sporadic costs, such as boiler repairs and vet’s bills. Let’s look at a few scenarios:

You’re paying off credit card debt – in this case, it might seem sensible to devote the maximum amount to clearing those outstanding balances. However, an unexpected expense or drop in income might force you into borrowing more. Dave Ramsey, squillionaire author of The Total Money Makeover, suggests building a reserve fund of $1,000 (almost £800) alongside your repayments. It’ll take longer to become debt-free, but you’ll have some protection against life events that could throw you off course.

You have heavy financial responsibilities – perhaps you’re the breadwinner, or you have a large mortgage to service. If so, you’ll need a correspondingly large emergency fund, around six months’ outgoings. This would provide a decent buffer if you lost your job or suffered a serious illness. Another option would be to take out appropriate insurance cover. As a financial coach, this is not an area I cover, but I recommend Pete Matthew’s Meaningful Money Handbook for excellent coverage of the types of policy available.

You’re financially comfortable – if you have a partner with a reliable income, or your expenses are modest, you can get away with a smaller emergency fund. Three months’ outgoings might be enough. It could take you longer to recover from a serious blow, but at least you have some time to consider other options.

If you’re finding it tough to put aside extra money each month, take a look at my post on paying yourself first.

Where should I stash my emergency cash?

Photo of the P
Hide your cash behind the Pennines? (Photo by Stemonitis CC-BY 2.5)

Given my warning about inflation, you might be concerned about keeping a cash reserve. However, this is an emergency fund, rather than long-term savings that you’re expecting to grow. You could consider it a DIY insurance policy, and the small amount of money you lose to inflation is the premium. Having said that, some banks are now offering rates that match – and, in some cases, exceed – inflation. You need an account you can access quickly and without penalties, so check the terms and conditions for any attractive-looking deals. Equally, you probably don’t want an account you can dip into too easily – so keep it separate from general spending. In Mind Over Money, Claudia Hammond suggests opening an account with a geographically distant financial institution, e.g. a Lancashire-based building society if you’re in London. Although your money is accessible online, it feels further away.

You can earn up to £1,000 in interest before you’re liable for basic rate income tax.1 Given the current derisory interest rates, you’d need a balance of nearly £60K before that would affect you. For this reason, it’s usually not worth using your ISA allowance, as you don’t benefit from the tax-free status. In my next post, I’ll introduce cash ISAs and explain the circumstances in which they might be appropriate.

In the meantime, please indulge in some modest catastrophising so you can protect yourself against life’s surprises.

 

  1. For higher-rate taxpayers, the threshold is £500 [↩]

Why Cash isn’t King

Photo of banknotes pegged to a washing line
Photo courtesy of https://www.flickr.com/photos/59937401@N07/

In uncertain times, stashing away banknotes can help us feel more secure. This was certainly the case with my grandparents, who kept emergency savings under their pillow. Unfortunately, they forgot and popped all the bed linen in the washing machine. Luckily, the world’s unlikeliest money launderers didn’t lose their savings. As the serial numbers on the notes had survived the spin cycle, the local building society was willing to accept them.1 Even when safely deposited in a savings account, my grandparents’ money remained vulnerable to another threat: inflation.

Inflation is the process by which prices increase over time, and it’s also how money loses its value. The effect is barely perceptible on small amounts of money in periods of low inflation, but it can have a dramatic impact over the long term. This chart shows what’s happened to inflation over the last 10 years. Although the rate has dropped this week to 1.8%, it was over 3% at the beginning of last year.

Of course, your savings are probably earning interest from the bank – but does this rate actually beat inflation? Your money could be shrinking faster than it can grow. Here’s an illustration. Imagine you’re 60 years old and have saved £300,000 in cash for your retirement or withdrawn that amount from your pension pot. Assuming inflation is 3% and you’re earning an interest rate of 2%, your money is shrinking by 1% each year. By the time you’re 85, that £300,000 has the purchasing power of £229,836. To make matters worse, you’re liable for tax on the interest. A basic-rate taxpayer would owe around £1,000 each year based on this scenario.2

Chart showing the effect of inflation
Chart generated by Moneyscope

What you need, therefore, is an interest rate that’s higher than inflation. This isn’t straightforward, though. Many savings accounts pay less than 0.5%, making it almost impossible to achieve growth – especially if you’re liable for tax on the interest.

Over the next few posts, I’m going to present some ideas on how you can grow your money. We’ll look at ISAs, savings certificates, premium bonds, and more. I’ll also introduce you to the basics of investing and how it differs crucially from cash. For now, remember that your money is safe in a savings account, but its value is at risk.

  1. This is unlikely to happen these days. [↩]
  2. You can earn up to £1,000 in interest each year before you start paying tax. For higher-rate taxpayers, the threshold is £500. [↩]

Help! I’ve ignored my pension – Part 3 – Working out how much you need

Depending on how old you are, retirement might seem like a very distant prospect. How on earth can you predict what you’ll want to do or what that’ll cost? This is why many people delay starting a pension. Will you be sitting in front of Countdown with a cup of tea or scampering around the world having adventures? Spending some time thinking through your likely expenditure makes it much easier to plan for the future.

In this post, I’ll talk you through some exercises to help you decide what you’ll need. Please note, the content below requires you to contemplate old age, infirmity, and death, so perhaps save it for a sunny day.

Working Out Your Expenditure

Popular advice holds that you need two-thirds of your current income when you retire. This might give you a target to aim for, but it’s based on a number of potentially unhelpful assumptions, for example, that you’ll have paid off your mortgage.

  • If you rent your home, your housing costs (which are usually the largest expense) won’t change.
  • If you walk to work or are based at home, you won’t save the cost of a season ticket or parking charges.
  • If you have children, your expenditure drops when they leave home, but perhaps you’ll be spending on grandchildren or helping out with loans.

So, depending on your situation, your income might need to remain fairly static after retirement. Here are three steps to achieve a more accurate prediction:

  1. If you haven’t done so already, download the MoneySavingExpert budget planner and enter your current outgoings
  2. Make a copy of the budget, then tweak it for early This is hopefully the period where you’re still active and taking advantage of your freedom. You might be reducing some costs, e.g. mortgage, pension contributions, season ticket or petrol, but increasing others, such as holidays.
  3. Now make another copy and think about late retirement – when you slow down and spend more time at home. This stage can be depressing, as it forces you to consider the less active part of your life. It’s possible you’ll be going on fewer holidays, but spending more on services, such as gardeners and taxis. Your heating costs could rise significantly, too.

Of course, you can’t predict the future. However, even a rough calculation makes planning easier.

Comparing Income with Expenditure

Now you know how much you need, it’s time to compare this with your projected income (head over to Part 1 of this series for tips on how to discover your pension entitlements). If you have a final salary (or Defined Benefit) pension scheme, this is easy. Your statement should show your guaranteed annual income, based on the specified retirement age. Retire earlier and you’ll receive a lower amount. Don’t forget that your pension is also subject to income tax. If you receive £20,000 pa, you’ll pay £1,628 in tax.1 Assuming you’ve reached the state pension age, you no longer need to pay National Insurance.

Those of you who have a Defined Contribution (or Money Purchase) pension or other retirement savings need to do some sums. Essentially, you’re trying to work out how to make a pot of money last throughout your retirement. This is straightforward if you know three things:

  • How long you’ll live
  • How the stock market will perform
  • What will happen to inflation

That’s right, it’s an almost impossible task. Take too much too soon and you could spend your final years in penury; take too little and you’ll deny yourself some fun and potentially leave the taxman with a large windfall. To get an idea of how long you’ll live, try this life expectancy calculator from the Office for National Statistics.

My life expectancy is 86, but there’s a 1 in 4 chance that I’ll make it to 94, and a 1 in 10 ‘risk’ of becoming a centenarian. As I don’t have a final salary pension, I’ve planned a fund that’ll stretch more than 30 years.

The Which? Income Draw Down Calculator helps you work out how much money you might need, and it’ll also factor in inflation and stock market performance. For example, if you had a pension pot of £300K invested in a mix of funds and bonds, then withdrew £30K pa, you’d run out of money in year 12 of your retirement.

Screenshot of income drawdown calculator

Errk. Reducing your income to £24K gives you another 4 years of funded retirement. Experiment with your own figures to discover the implications of different scenarios. You might find that the retirement income you hoped for is difficult to achieve.

One way of avoiding these risks is to buy an annuity from an insurance company, some of which give you a guaranteed inflation-linked income for life. The downside is that you pay a high price for that security. The cost depends on factors including your age, health, and even your postcode. Purchasing an annuity is a major decision, as you can’t change your mind afterwards. For more information, visit the Money Advice Service guide. You’ll also find a questionnaire that’ll estimate how much you could receive from an annuity.

In this example, choosing an inflation-linked annuity for a pension pot of £300K generates a secure, guaranteed annual income of almost £10,000.2 But managing it yourself could result in £16,000, assuming you don’t live too long. You’re possibly paying £6K pa for that security. The exact figures depend on your personal circumstances and when you retire. The questionnaire – which includes helpful videos to explain every step – does give you an idea of the compromises, though.

What if there’s a shortfall?

Perhaps you’ve played with the calculators and the numbers aren’t stacking up. If you’re close to retirement, it’s a good idea to get advice from a Certified Financial Planner. Although expensive, they can perform far more sophisticated calculations and also advise you on how to invest your money. Otherwise, there are several options to consider:

  • Decrease your projected retirement income. Are there any areas of expenditure you could reconsider? This might include downsizing and/or moving to an area where you no longer need a car.
  • Retire later. This gives your pension pot longer to grow and reduces the number of years you’re drawing on it. If you don’t enjoy your current job, ponder what else you might do. Take a look at my post on Finding Your Ikigai for some tips on identifying a career that’s right for you.
  • Build your assets. In my previous post, I explained some options on saving for retirement. You could possibly boost your income by starting a side hustle or renting a room. Also, review your outgoings with a critical eye. Small savings across multiple expenses could add up to a significant sum.

In future posts, I’ll explain more about savings and investments, and also demonstrate the impact of inflation on long-term financial planning.

Conclusion

Confronting old age is sometimes a frightening experience, especially if you discover a gap in your finances. But it’s best to deal with the problem as soon as possible. There are always options, but you need to face the facts first. Taking action now could mean a long and happy retirement.

As a financial coach, I can guide you through the process of your pension healthcheck. By explaining the options available and using forecasting tools, I support you in making an informed decision that’s suitable for your situation.  I never recommend a specific product or course of action. If you require advice rather than coaching, you need to see a qualified financial advisor. They’ll either recommend products on which they receive commission, or you’ll pay a fee for independent advice. Please contact me if you’d like a free 15-minute chat about pensions or any other aspect of financial wellbeing.

  1. Based on the 2018/19 rates. [↩]
  2. Based on a 65-year-old non-smoking woman starting an annuity in November 2019. [↩]