An investor needs a retirement fund of Rs 6 crore when she retires at 60 years old, which is 35 years away. She comes across three popular planning options to help decide the monthly SIP:
Start a Rs 5,000 SIP assuming a 14.5 percent annual return
Start a Rs 9,500 SIP assuming a 12 percent annual return
Start a Rs 5,000 SIP assuming a 12 percent annual return but increase the SIP amount every year by 7 percent.
As an astute investor she realizes she should not count on higher returns to meet her retirement goal. It is better to assume a lower and more reasonable long-term rate of return. So, option A is out.
Between option B and C it gets interesting. The returns assumptions are the same – 12 percent annually. However, she gets to start with a lower amount in C which leaves more for her current consumption. Yes, the SIP needs to be increased by 7 percent every year, but that should be fine, right? Option C is popularly called the step-up SIP. Before you commit to it, let’s dig a bit deeper to see what’s really happening here.
The chart below shows the total amount invested (in lakhs) over time (months) in both the options:
In this example, the total investment required for the step-up SIP in Option C is Rs 83 lakhs while for the simple SIP in Option B it is Rs 40 lakhs. So, to achieve the same outcome step-up SIP will require her to invest 2x the amount over the same time. However, for the first half of her investment journey she would have more surplus to spend.
The total invested amount in a step-up SIP explodes towards goal maturity because for a step-up SIP the power of compounding is also working against her - her SIP amount is also compounding at an 7 percent annual rate. Most investors find it hard to visualize long term compounding impact – our primal brains are not wired for that. And step-up SIP calculators conveniently hide this data.
The chart below shows SIP amount (Rs thousand) over time (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 also opens up another conundrum that most calculators hide behind the math. 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.
So what’s happening here? 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 the road schemes. Save less now, have more to spend now and then have your future self-sort it out later. But in our happiness that we have more to spend now 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.
So does it mean step-up SIP is all bad. Not 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. But 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. Now whenever an opportunity arises, step-up your SIP so that you can reach your financial goals faster. That would be a smart move.
(Gaurav Rastogi is the Founder & CEO of Kuvera.in, a free direct mutual fund investing platform)
