The danger of using two-pot retirement system savings for emergencies

It is dangerous to use the money in the savings pot to pay when you encounter emergencies, although the two-pot retirement system was designed to give pension fund members access to their retirement savings in an emergency.

Traditional financial advice recommends maintaining an amount equal to three months’ worth of expenses in an emergency fund. However, inflation erodes the value of cash, making it challenging to keep pace with rising costs.

Therefore, some people consider placing emergency savings in tax-deductible retirement fund vehicles to benefit from potentially higher returns, especially with the flexible access options provided by the new two-pot retirement system.

Keith Peter, advice manager at Old Mutual Personal Finance, cautions that this strategy is risky and he encourages people to think carefully before using market-linked retirement funds for this purpose.

“During the Covid-19 pandemic, markets experienced steep drops, leaving many people who relied on their investments for emergencies withdrawing funds at a significant loss. This likely severely undermined the value of this money, causing many to go into debt at a time when they needed cash the most.”

ALSO READ: Here’s why you need an emergency fund – and it’s not to buy new golf clubs

How to manage inflation risk of savings

Peter advises South Africans to rather manage inflation risk by starting with a holistic financial plan that includes emergency savings and retirement savings, as well as insurance. 

“A realistic emergency fund should start with a holistic financial plan, which is a comprehensive strategy that considers all aspects of your financial health. This ensures that your emergency savings are aligned with your actual needs and priorities.”

He says adequate insurance, such as vehicle, retrenchment and income protection and medical or gap cover can reduce the need to accumulate large cash reserves for emergencies, as specific risks are already covered.

ALSO READ: Two-pot retirement system: rather set up a separate emergency fund

Your plan for emergencies

“The plan should determine how much cash is required for emergencies and what risks are already covered by insurance, such as medical aid, gap cover, or vehicle cover. For instance, if you already have gap cover for medical expenses, you do not need to set aside additional funds for medical emergencies.

“It is like paying for an additional external fitness class when an existing gym membership includes that class. By clarifying these details, you can avoid ‘over-saving’ in cash reserves that inflation could erode, while still being adequately prepared for unexpected events.”

Only after these elements are accounted for should you select the most suitable savings vehicles, including whether to consider a tax-free option. “Once you assessed your financial risks, insurance and tax obligations and have the right insurance in place, choosing the right type of emergency savings account becomes easier.”

Peter points out that there are a variety of savings vehicles available but stresses that a minimum requirement is a vehicle where the money is guaranteed, not linked to the stock market and fairly easy to access.

ALSO READ: Two-pot retirement system: how to resist the temptation of withdrawing

Checklist for building a fund for emergencies

He shares this checklist for building a smart emergency fund:

• Set a realistic emergency fund goal based on actual expenses. Calculate an emergency fund amount based on your essential expenses, tailored to your specific needs. Consulting with a financial adviser can help you create a customised safety net, ensuring your fund is neither too large nor too small.
• Limit cash exposure with proper insurance coverage. Review your insurance coverage, including medical aid, vehicle insurance and gap cover, to see what is already protected. With adequate insurance, you can maintain a smaller cash reserve, knowing that major expenses are covered.
• Choose stable and accessible savings vehicles. Once you understand your risks, select a savings vehicle that offers growth above inflation and quick and easy accessibility. Avoid volatile investments, such as equities, which may experience sharp drops and are less reliable for emergency needs.
• Avoid keeping emergency cash in low-interest accounts. Holding cash in low-interest accounts, or “under the mattress,” leaves it vulnerable to inflation. Opt for a savings vehicle that balances growth with accessibility, protecting the purchasing power of your emergency funds.
• Reassess your emergency fund regularly. Review your emergency fund periodically, especially if it has not been used for some time, to ensure it is still big enough. If you have more than you need, consider reallocating some to higher-yield investments to keep up with inflation.