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Developing a Contingency Funding Plan


Checklist Description

This checklist describes why it is important to set up a contingency fund, how to define its uses, and some traps to avoid.

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Definition

A contingency fund is an amount of money that’s kept in reserve for use in times when other funding resources have run out. In this way, the contingency fund can help guard against possible losses of important assets. In short, it’s about sound budgeting for emergencies and the unexpected.

Historically, banks or companies have generally failed because they had no meaningful contingency plan. Indeed, banks with a sound contingency funding plan are considered much more likely to survive a funding crisis. While no retail bank actually failed during the global credit crunch of 2007–08, the British-based Northern Rock came close after fears over its liquidity caused customers to make a run on its funds and the Bank of England was forced to step in and shore up its finances. Having a credible contingency funding plan enables a bank or organization to forecast its liquidity in various worst-case scenarios.

The sensible realization that at some time in the future things might not be rosy is the first step towards setting up a contingency fund. Financial resources can run dry quickly in an emergency, forcing an organization to look elsewhere for funding. Having a contingency fund can help avoid the need to rely on other entities.

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Advantages

  • A contingency fund can help to relieve an organization of financial problems in times of difficulty.

  • A contingency fund may even save an organization from going under.

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Disadvantages

  • Salting away money into a contingency fund can seem like wasting money that could be used elsewhere, for example, for running the business, buying more assets, etc.

  • It can be tempting to use the money in a contingency fund for other “emergencies” that are not actually defined for the use of the fund.

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Action Checklist

  • Decide what the contingency fund will be for. Draw up a list of all possible situations where things might go wrong (worst-case scenarios) that are not covered by your insurance policies and consider under what circumstances you might need to draw on a contingency fund. This will help to define the uses for the fund. Then calculate how much it would cost in total to fund those areas of concern, and start setting aside spare cash in the contingency fund.

  • Establish a set of rules for its use. In what circumstances will it be used? How much of the contingency fund can be used for a particular event or at one time? How long should it last? The uses of a contingency fund should be clearly defined. Veering from the rules for its use could compromise the financial health of the organization should a real need for the fund ever arise. Don’t view it as a handy pot of money to dip into whenever needed.

  • Establish a budget. Determine how much money to feed into the fund, and how often.

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Dos and Don’ts

Do

  • Establish a budget.

  • Decide exactly what the contingency fund will be for.

  • Move money into the fund as appropriate.

  • Automate saving into the fund so that it is not optional. Set up a standing order at the bank to ensure a regular transfer of money.

  • Take advantage of the best savings account available so that the contingency fund earns interest while not in active use.

Don’t

  • Don’t ignore the rules for the use of the fund.

  • Don’t miss payments into the fund.

  • Don’t withdraw from the fund for purposes other than those for which it was set up, or before the end of a predefined period.

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Further reading

Book:

  • Nissenbaum, Martin, Barbara J. Raasch, and Charles L. Ratner. Ernst & Young’s Personal Financial Planning Guide. 5th ed. Hoboken, NJ: Wiley, 2004.

Article:

  • Nelson, Michael. “Establishing a capital contingency fund for utilities.” Public Works (October 1994).

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