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What are the best investment vehicles for holding a safe and highly liquid Emergency Fund? That’s the focus of the third in my latest series of blogs for Motley Fool Canada introducing the basic principles of establishing Financial Independence.
You can find the latest instalment by clicking on the highlighted headline here: One Essential Tip for Achieving Financial Freedom.
In the first two installments of this new series of articles, we looked at two key steps toward Financial Independence: jettisoning debt and, once that is accomplished, applying the resulting surplus to savings and ultimately long-term investments.
As the latest blog argues, you could even argue that an emergency cash cushion should take precedence over both debt elimination and saving/investing.
What should you be looking at in an Emergency Fund? First, you need liquidity: the ability to access the cash at a moment’s notice. Second, you want safety of capital, which really means cash equivalents or fixed income, not equities normally held with a time horizon of more than five years. Third, assuming some sort of fixed income that’s not locked up like a 5-year GIC, you want at least a reasonable rate of interest to be paid on it.
Normally, you shouldn’t regard RRSP investments as an emergency cushion, since you’ll have to pay tax to access the funds. Most people will try to keep relatively high cash balances in their chequing accounts that can serve as a cushion, although typically these accounts pay next to nothing in interest income. One possibility is short-term or redeemable GICs that may pay somewhere between 1 and 2% per annum. Another good place to “park” such funds is a High Interest Savings Account (HISA).
As the name suggests, HISAs pay high amounts of interest, usually more than 2%. According to this source, several pay more than that: as of mid 2019, EQ Bank was paying 2.3%, Motus Bank up to 2.5%, Tangerine was offering a promotional rate of 2.75%, and Motive Financial was paying 2.8%, Wealth One Bank of Canada was paying 2.3% and WealthSimple 2%. Pretty nice returns for liquid cash cushions!
A Tax-free Savings Account (TFSA) can be a fine place to hold emergency savings. Unlike the RRSP there is no tax penalty to access the funds. Odds are your TFSA investments will be invested in longer-term equity and fixed-income vehicles but there’s no reason a fixed income ETF couldn’t be liquidated in the event of a true financial emergency. Just remember to replace the amount you withdrew the following calendar year so as not to lose the valuable tax break that the TFSA provides; since it would have been an emergency, the need to tap TFSA funds shouldn’t happen too often.
Generally, bond ETFs can be liquidated just as easily as equity ETFs, though unlike GICs, they may be underwater when you do. Guaranteed Investment Certificates most commonly require you to lock up your money for anywhere between two and five years, even though they don’t pay significantly more than HISAs, if at all. Cashable or Redeemable GICs make more sense for emergency funds but they will pay less interest than non-redeemable GICs and probably less than most HISAs. If you can get 1.5 to 1.8% you’ll be doing well.
These days another alternative is money market mutual funds or, if you can find them, money market ETFs or short-term bond ETFs. Many don’t pay much but a handful have decent yields: iShares Premium Money Market ETF (CMR/TSX) has a 12-month trailing yield of 1.54% and a distribution yield of 1.22% while the Purpose High Interest Savings ETF (PSA/TSX) yields 2.15%.
Another alternative are treasury bills or T-bills, usually issued by the federal or provincial governments; these are high-quality debt securities with a term under one year. Most of the banks also offer T-bill funds (such as the RBC Canadian T-Bill Fund). You may have to commit to at least $5,000 to buy a T-bill and you may be penalized for taking the money out early. Commercial paper may pay a bit more than a T-bill and face the same $5,000 minimum purchase and early-redemption penalty.
By definition, emergency savings are unexpected and when they do crop up, you’ll need a liquid source of funds that aren’t subject to market fluctuations or early withdrawal penalties. Don’t expect huge rates of interest, since high liquidity usually means agreeing to less flexibility than you’d want for the main purpose of this fund: emergencies. Any interest you can get should be considered a bonus, but should be trumped by safety and liquidity. And be realistic about how big an emergency fund you need: beyond a certain point, your money will be working harder in longer-term investments held in RRSPs and TFSAs.
