Having a large amount of money in the bank does not necessarily mean that you are financially secure. The more important question is whether your can keep your household running if your income stops or an unexpected financial shock hits.
The right financial cushion depends on your monthly expenses, liabilities, dependants, income stability, insurance coverage and stage of life. Financial planners generally recommend building the cushion around expenses rather than income because it is meant to replace cash flow when earnings are disrupted.
Start with your monthly expenses
The first step is to calculate your total monthly outflow. This should include essential household expenses as well as financial commitments that cannot be postponed.
“Start from expenses, not income, a cushion exists to keep the household running if income stops, so what you spend is the number that matters,” said Akshay Saapru, Group CEO, FundsIndia.
This calculation should include fixed liabilities such as EMIs, insurance premiums and school fees, along with other essential household expenses. The resulting monthly outflow can then be multiplied by the number of months of protection required based on an individual’s circumstances.
Dependants are also important. A single-income household supporting a family may need a larger cushion than a dual-income household because there is no second income to fall back on if the primary earner loses their job.
How much should you keep aside?
The appropriate number of months depends largely on the stability and predictability of income.
For salaried employees, Saapru suggests a cushion of around six months of expenses, given that a job search generally has a more predictable timeline.
Self-employed professionals should consider a larger reserve of around nine to twelve months because their income can fluctuate and a weak business period may not have a clearly defined end date.
Business owners should maintain at least six to nine months of expenses, with one year being a safer target, according to Saapru. Personal and business cash flows can often overlap, meaning a household’s savings may also have to absorb periods of weak business income.
Retirees need to look at the cushion differently. Since there is no employment income to replace, the objective is to avoid selling long-term investments, particularly equities, during a market downturn.
“For a retiree, one to two years of expenses in liquid, low-risk instruments” can help ensure that the rest of the portfolio does not have to be disturbed at an unfavourable time, Saapru said.
Insurance can reduce the savings burden
Insurance is another important part of the calculation. Adequate and term insurance can prevent a major medical expense or loss of income from rapidly depleting savings.
“Term and health insurance are essential, not optional add-ons,” Saapru said.
With adequate insurance, large and unpredictable financial shocks can be transferred to the insurer, leaving the emergency cushion to deal with temporary disruptions. Without sufficient insurance, however, savings may have to absorb a hospitalisation or the financial consequences of losing an earning member.
Saapru also recommends buying insurance early, when premiums are generally lower, and reviewing the coverage as income, age and the number of dependants change.
Inflation can make today’s cushion inadequate
The amount required for financial security is not static. As household expenses rise, the financial cushion needs to be recalculated.
“Six months of today’s expenses is undersized for six months of expenses three years out,” Saapru said, pointing particularly to healthcare and education costs, which can rise faster than headline inflation.
Therefore, the target should be reviewed at least once a year against actual household spending. The money also needs to retain its purchasing power while it is waiting to be used. While the most liquid portion should remain readily accessible, keeping the entire cushion in a low-yield savings account for several years can erode its real value because of inflation.
Your age also changes the calculation
The ideal cushion changes through different stages of life because both financial responsibilities and income risks evolve.
In the 20s, an individual may have relatively low expenses and fewer dependants, but income can be less stable because of career changes. Saapru therefore suggests that a slightly larger multiple of expenses can make sense even when the underlying monthly spending is low.
The cushion often becomes largest in the 30s and 40s, when financial responsibilities can overlap. EMIs, children’s education and support for ageing parents can all increase the amount of money a household needs to keep readily available.
By the 50s, income may have become more stable and some dependants may be financially independent. However, the purpose of the cushion changes as retirement approaches. It increasingly becomes a bridge to retirement and a way of protecting the corpus from having to be tapped during an unfavourable market period.
The key takeaway is that there is no universal savings figure that guarantees financial security. The appropriate cushion is the amount that can cover essential expenses and fixed commitments for an appropriate period, while insurance and long-term investments serve their respective purposes.