Build a financial lifeboat

Why do contingency planning?

Financial planning typically means anticipating current and future income,expenditure and requirements,while keeping inflation in mind. It is equivalent to preparing a family balance sheet. If a financial plan were regarded as a pyramid,emergency or contingency planning constitutes its base. In the course of my own financial planning practice,I have come across scores of people who have insurance plans,home loans,car loans,personal loans,and investments,but no emergency funds.

Following the recent global economic downturn,the most obvious reason why a contingency plan needs to be created is to safeguard against the loss of a job or an income. A prolonged illness to the breadwinner,which again entails a loss of income,is another reason for contingency planning.

Most people believe that a corpus equivalent to three to six months income is adequate for an emergency fund. However,based on age,profession,and number of dependants,some people may even need to create a fund equivalent to one years income,and in extreme cases,possibly more.

Come to terms with your fears

Each of us has a unique psychological relationship with money. Our spending and saving habits are governed by our past experiences. Hence,each person perceives financial security differently. While making a contingency plan,the first questions should be: What do I worry about the most? and What are my biggest fears? Based on an honest response to these questions,try to get to the root of your fears,which are usually linked to finances.

I have a friend who has a sea-facing house in Mumbai. He recently invested his savings into buying another apartment in the same area. While preparing his financial plan,I realised that he has a fear of the sea level rising due to global warming. He fears that he will stand to lose a large part of his wealth even if the sea level were to rise marginally,as it could cause real estate prices to crash in tie area where his houses are situated. As part of his contingency plan,I suggested that he should consider investing in a property in either Navi Mumbai or Pune to address his concern,however far-fetched it might appear to others.

The goal while probing fears is to identify them,including irrational ones,which hold back an individual from making long-term investments. At this stage,one may also have to acknowledge and factor in risks that one has not given thought to previously. For instance,an individual who keeps 90 percent of his savings in equities stands the risk of losing a large part of it if the market crashes. If you go through a proper financial planning exercise,your financial planner will ensure that all your eggs are not kept in one basket. Just as having an extremely high exposure to debt or equity is not advisable,the same way not having any exposure to such instruments is also not advisable as it could result in a failure to reach your long-term financial goals. Proper allocation of funds is fundamental to financial planning.

Key steps in contingency planning

A few important points need to be adhered to while creating a contingency plan:

Create an emergency fund account

Based on your profession,age,and liabilities,define the size of your emergency fund. Create a separate bank account to set aside the money for this fund. You could consider options such as fixed deposits,liquid funds and short-term debt plans of mutual funds. Irrespective of the instrument chosen,it should be sufficiently liquid to ensure that you can access your funds quickly when you need them.

Are you adequately insured?

If you have a major liability,such as a home loan,then buy an insurance policy to cover the loan. Also look at options for an umbrella policy that will protect you against unforeseen liability claims. Further,adequate life insurance cover is a must-have for every individual.

Pay off costly debt first

If you have any outstanding payments towards credit cards,clear them off first. Keep a check on your card spends. If need be,call your bank and ask it to revise your credit limit downwards based on your spending capacity. Be disciplined in your approach towards using credit cards.

Arrange for backup financing

It is also advisable to secure other forms of financing that you can avail of during emergencies. It could be a loan against property or some other illiquid asset. Know the value of your assets,the formalities required,and the maximum loan that you can take against it. hen you are borrowing funds against assets the amount should not exceed 30-40 per cent of the asset value.

Developing a contingency plan does not reduce the likelihood of facing financial uncertainty. However,by making a plan and doing adequate preparation,one at least gets an opportunity to resolve problems with a comparatively relaxed frame of mind. You can compare creating an emergency fund to the assurance with which Sehwag bats when he opens the innings,knowing that Sachin and Dravid are there to secure the ship in case he fails.

The author is founder and managing director,Financial Freedom Financial Planners