Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.— Ronald Reagan
An emergency fund is a pot of money, at least 6 months’ worth of expenses, that you use to end a financial emergency. It stops you going into debt and keeps your financial life healthy.
Once people squirrel away their minimum of 6 months’ worth of expenses, people tend to forget about the emergency fund and move onto other parts of their financial life, such as saving for a house deposit, saving into a pension, saving into a stocks and shares ISA to invest in the stock market via Vanguard.
This “build and forget” approach to an emergency fund is, on one hand, a good thing as you don’t keep dipping into the fund when you want to buy some consumer crack such as a new TV, or new car, or holiday to hot, dusty Spain. You only reach for that fund in a real emergency, like losing your job.
But the problem with the “build and forget” approach is that inflation is attacking your emergency fund every day.
Inflation is the killer of cash. Inflation is the cost of products and services increasing over time. An example is in 1980 my dad purchased a three bedroom house in the south east of England for £18,000. In 2009 when we sold, it was worth £157,500. If he had saved the £18,000 in an emergency fund expecting to buy a house with it in 2009 he would have been shocked, and out of luck. That £18,000 in 2020, 11 years later, would be worth even less. It wouldn’t buy a bottom of the range VW Tiguan. Why? Inflation.
Over time, the cost of goods and services, usually, go up. Some things might go down. Such as a computer in 1980 would have cost a small fortune. In 2020 a computer is vastly cheaper, and more powerful. That’s because the producers of the computer and all its components have improved their processes to make computers cheaper, which allows them to lower the price, and instead of selling to thousands, they sell to billions of people.
Yet with most products and services, inflation drives the price up. When I was a child a Mars bar cost 10p. Nowadays, I’m lucky if I get a one for less that £1. That’s inflation. Same with services, I used to get my car cleaned for £5 in the late nineties, today, if I take it to the car wash, it’s £20+. Of course, at that price, I do it myself and bank the £20.
How to keep inflation from killing your emergency fund?
There are three options to stop your emergency fund getting eroded by inflation. I recommend doing all three:
- Decrease your expenses – If your monthly expenses are £1,000, that would mean you have a minimum of £6,000 in your emergency fund. You can reduce your expenses, such as cancelling the gym subscription, as you haven’t entered the gym since it was refurnished… four year ago. The lower your expenses, the further your emergency fund spreads. In our example, reducing your expenses to £900 would mean that you only needed £5,400, so you’d actually have £600 surplus. This is a bit of a cheat really, as your £6,000 is still getting eaten by inflation, but it definitely helps. Plus, reducing your expenses should be a lifelong practice. Any money you pay out on expenses is not being saved and not earning interest, which compounds and earns more money.
- High interest ISA/savings account – Putting your emergency fund into a savings vehicle such as a cash ISA or savings account is wise, as it allows you to access it immediately. You should shop around for an account this gives you immediate access to all the money, which offers the highest interest. At the moment interest rates are lower than a limbo dancer’s balls, so finding a rate that equals or beats inflation is almost impossible. People use between 2% and 3% to measure inflation. If you get an interest rate in your savings account of 1% then if the inflation rate is 3% your emergency fund is only losing 2% rather than 3%.
- Contribute more cash – Once you hit your financial goal of at least 6 months’ worth of expenses for your emergency fund, it’s time for you to move on and tackle another financial goal, such as investing or saving for a house deposit, but what you should do each year it top up your emergency fund by a certain percentage amount. If we use 3% as the inflation rate, then your emergency fund needs to increase from £6,000 + 3% (£180) = £6,180. If you have a good interest rate on the ISA of say, 1%, then you only need to top it up with 2% (£120). For my piece of mind, I’ll always top it up by 3% myself and let the interest the emergency fund is earning do its thing. I usually add this additional 3% right at the beginning of the tax year 06/04/20XX just so I can cross that financial goal off my list, forget about it, and then concentrate pushing all my money into my workplace pension and my Vanguard index fund. Plus the earlier I do it, the longer the interest has to build up until the end of the next tax year.
So there are just three simply ways to stop your emergency fund getting chewed up by inflation, with minimal contributions. The emergency fund is a beautiful thing. We work so hard to build it that we don’t want anything to happen to it. By contribution 3% a year you’ll help keep it in tip top shape.