How to create a perfect financial plan - part 2. Where and how to put your savings

27 July 2020

In our last budgeting blog post we helped explain how you can track and measure your budget, the next most important part is figuring out where to put this money. The best and most effective way to save your money over time is developing a good, easy to use a system for your spending.

We recommend dividing things up into the following four buckets, which we’ll explain in more detail:

  • Everyday/transactional
  • Emergency fund
  • Generic Savings
  • Long term  goal/ retirement

The most important two houses to get in order are the first on the list, your transactional account for your everyday expenses that keep your world going round, and the second for when your world stops spinning, or your emergency fund.  The third and fourth are the real driving forces for your personal wealth, and which we’ll help you get your head around.

 

Everyday / transactional account

As much as you try to pinch your pennies, spending is part of living.  You should try and limit what you keep in this account to your next few weeks worths of expenses, covering all of your regular expenses, from supermarket trips through to autopayments like rent. You likely already have something like this going, but it’s important to be clear on its purpose and treat it as such.  

Where should you put it: An everyday cheque account is really the only place for your day to day money.  A bank account that won’t charge you transactional fees, and if possible still gives you a little bit of interest on your balances is what you should be looking for.

 

Emergency Fund

The emergency fund is money you put aside for urgent, unexpected costs. Basically your “rainy day” fund. It may sound like heaps, but we recommend that you try to stack up against your emergency fund with 3-6 months worth of typical expenses in your everyday account so that you have some decent breathing room if shit hits the fan.   

This account is set up to pay for things like your car breaking down, you losing your job, or dealing with a leak springing over winter.

Where should you put it: The best place for your emergency savings account is a bank savings account or term deposit.  This type of account will generally penalize you for transactions, though it will allow you to earn a tiny bit of interest on your savings. 

An alternative option to an Emergency Fund is an offset mortgage account.  Often your mortgage will have an offset facility (basically an overdraft) which can be drawn down when necessary.  This mortgage will incur the same interest as your mortgage, so much better than your typical credit card or personal loan. 

Make sure that if you dip into your emergency fund, afterwards that you top it up again.

 

Your savings

The trickiest of your saving pillars to think about is the unallocated savings bucket. This bucket is for anything left over after your paycheck, day to day spending, and KiwiSaver contributions.  For most people, there are really four types of investment that they can invest in, cash/term deposits, fixed interest/bonds, property and shares.  

 

What does it represent?

Expected annual return

Minimum suggested timeframe

Estimated number of negative annual returns over 20 years

Cash / Term deposits

Money sitting in a bank

1%

Daily

Never

Fixed Interest / Bonds

Lending money to companies

2.5%

2 years

2 in every 20 years

Direct property

Owning a house or commercial building

4.0%

10+ years

2 in every 20 years

Shares

Owning a slice of a company

5.5%

5-10 years

6 in every 20 years

 

As you can see, each of the different investment types has different return and risk profiles. Shares have the highest return of the different asset classes, though have the highest chance of going awol, as we’ve seen a lot in recent months. This means they generally go up faster than everything else over time, though they will have periods of downturns.  Fixed Income and cash have lower rates of return, though will follow a more stable and steady path. 

Selecting what assets to invest in will be determined by your investment horizon (time until you need your money) and your risk tolerance:

  • If you are saving for a specific short term goal (eg. Saving to purchase a car next year, or saving for an OE)  you need to minimize your risk to ensure that you have enough cash to meet the short term goal you need to protect your downside risk.  There is nothing worse than needing to cancel your holiday or OE because of a market downturn.  The shorter-term your objective, the more you need to manage the downside and lower your risk profile.  That means don’t have your money in the share market if you’re planning on using it in the following few years. 

  • For a medium-term goal, you will need to strike a balance between protecting the amount of money you’re contributing and achieving growth that offsets inflation. The more time you have/ the more flexibility you have around timing, the more you risk you can afford to take on. 

To put this in the context you can see the expected outcomes of investing $500 per month for specific time periods in the table below.  You can see that it is only when you are invested for the very long term that you are guaranteed better outcomes by investing in equities versus fixed income.  The range of outcomes from cash and fixed income is much smaller than with equities.  

 

Where and how to put your savings table 1

 

Notes:

Based on Monte Carlo Simulation using 30 years of historical data as a reference point, Minimum equals 10th  percentile, Maximum equals 90th percentile, Expected equals 50th percentile.

If you are creating a generic savings pot for the longer term, then you can afford to take more risk.  Your primary concern is how comfortable you feel about the ups and downs of the markets in figuring out the amount of risk you should be taking on. Unfortunately, there is no one answer. Everyone is different.

Where should you put it: Our strong recommendation for saving using this bucket is managed funds.  In New Zealand, there is a wide range of managed funds available via InvestNow and Sharesies that will allow you to meet your savings goals in a very low-risk way.  We suggest you choose a range of passive fixed income and equity funds and create a blend that allows you to manage your risk properly.

 

Your Retirement Funds

Your retirement funds are a bit different, this is a long term investment that you cannot (or should not) touch until you retire.  With this fund, you can afford to take a fair amount of risk as the money is invested for the long term and you will be able to see through a number of market cycles.

As you approach and get closer to retirement, your retirement savings switches from being a long term savings vehicle into short/medium-term savings for a specific goal.  Therefore you need to reduce risk and start to manage your downside.  

 

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