Smart way to use step-up SIP
An investor needs a retirement fund of Rs 6 crore when she retires at the age of 60, which is 35 years away. She comes across three planning options to help decide the monthly SIP:
A. Start a Rs 5,000 SIP assuming a 14.5 per cent annual return
B. Start a Rs 9,500 SIP assuming a 12 per cent annual return
C. Start a Rs 5,000 SIP assuming a
12 per cent annual return but increase the SIP amount every year by
7 per cent
An astute investor realises higher returns will not help to meet retirement goal. It is better to assume a lower and reasonable long-term rate of return. So, option A is out.
Options B and C present the same: 12 per cent annually. However, she can start with a lower amount in C, leaving more for her current consumption. Option C is popularly called the step-up SIP. Let’s dig a bit deeper to see what’s really happening here.
The total invested amount in a stepup SIP explodes towards goal maturity because for a step-up SIP the power of compounding is also working against her — SIP amount is also compounding at 7 per cent annual rate. Most investors find it hard to visualise long-term compounding impact — our primal brains are not wired for that. And step-up SIP calculators conveniently hide this data.
The chart shows SIP amount (Rupees in thousand) over time
(in months) in both the options.
The step-up SIP amount grows 10x from Rs 5k/month to Rs 50k/month. While it may be trivial to believe that her SIP amount will keep pace, the real-world data doesn’t back this up. This has been solidified as the first principle of investing — invest as much as you can and as early as you can.
The compounding of SIP amount in a step-up SIP opens another conundrum. In this example, for a step-up SIP 30 percent of the invested amount is invested in the last five years. For the goal to be met you are highly dependent on the last five years.
Option C lights up the same corners of an investors brain that are targeted by 'buy now pay later' or other 'kick the can' down road schemes. Save less now, have more to spend now and then have your future selfsort it out later. But we forget that our future self may not be able to live up to all the obligations we are signing them up for. One bad turn of events and the house of maths comes tumbling down.
Not all step-up SIP is all bad, if you use it smartly. If you choose step-up SIP so that you have more to spend now, then you will likely be disappointed. You should use it to reach your goals faster. Start with a simple SIP construct and invest as much as you can as early as you can. Step-up your SIP later to reach your financial goals faster when opportunity arises.