We all know that a systematic investment plan (SIP) of a mutual fund gives us the added advantage of rupee cost averaging. But there is a problem in the traditional SIP. It assumes a constant SIP each month for a long period of time. But that is not the way your income grows. For example, if you are in a job then you get annual increments and if you are in business your revenues and profits will grow over a period of time. It would be therefore not be practical for you to assume the same amount of SIP for all these years. Is there a way to overcome this dichotomy?
The answer could lie in a step-up SIP. Let us understand the better way how to invest in SIP with a practical SIP investment calculator. Let us also understand how many years to invest in SIP to get the maximum benefit. But first let us look at the concept of stepped-up SIP.
Understanding a stepped-up SIP
A stepped up SIP entails automatically increasing your monthly SIP contribution on a periodic basis. Normally investors get their flows on a monthly basis and their packages tend to change on an annual basis. Hence the most popular form of stepping up the SIP is an annual approach. There are 2 ways of stepping up your SIP:
You can step up your SIP on fixed rupee basis each year. For example you can start a SIP of Rs.10,000 per month and then step up by Rs.2000 each year. So over the next 5 years the monthly SIP contribution will be 12,000, 14,000, 16,000 ….etc.
You can also step up your SIP on percentage basis each year. For example you can start a SIP of Rs.10,000 per month and then step up by 10% each year. So over the next 5 years the monthly SIP contribution will be 11,000, 12,100, 13,310 …. etc.
Normally, the fixed monthly accretion is more preferred compared to percentage accretion.
What are the advantages of a Step-Up SIP?
There are a few clear advantages that emerge from a step-up SIP to the investor:
It helps the investor to better synchronize the SIP investments with the growing income profile of the investor.
It inculcates an automatic discipline of investing more when you are earning more. That money may have been otherwise spent on unproductive purchases
The step up is decided in such a way that your marginal propensity to save is either constant or increasing. That is the key to long term wealth creation.
Does a step-up SIP really add wealth over the long run?
Obviously, when you invest more money for a longer period of time you are likely to create more wealth. But that is not the point! The point is that does it really help you to improve the wealth ratio; that is the ratio of your final corpus to the amount invested. Let us look at an illustration of stepped up SIPs and compare with a plain vanilla SIP. The time period considered in all the cases is 25 years..
SIP Amount (Monthly)Annual
Step-upRate of Return (%)Corpus InvestedFinal Corpus at endWealth Ratio step up SIPWealth Ratio static SIPRs.10,000Rs.200015%Rs.1.02 crRs.6.96 cr6.82 times10.95 timesRs.10,000Rs.300015%Rs.1.38 crRs.8.81 cr6.38 times10.95 timesRs.10,000Rs.500015%Rs.2.10 crRs.12.49 cr5.95 times10.95 timesRs.10,000Rs.600015%Rs.2.46 crRs.14.33 cr5.83 times10.95 times
If you look at the above table there is a paradoxical situation that emerges. Let us evaluate each option by the wealth ratio. The wealth ratio is the ratio of the final corpus to the corpus that you have invested without considering the time value of money. This gives a quick view how your money has managed to generate wealth in absolute terms. So what is the paradox about the step up SIP here? In fact, there are two paradoxes:
1. As you increase the step up amount on an annual basis you find that the wealth ratio is coming down. That is happening because your higher SIPs are happening for a lower time period and therefore the power of compounding is not working proportionately with the quantum of additional investment that you are committing each year.
2. If you compare the step-up SIP with the static SIP (where you just invest a fixed amount each month), the wealth ratio of the static SIP is much higher. Partially this is because the higher SIPs are being put to use for shorter periods. But it is also because the investment outlay in a static SIP is much lower and that makes the wealth ratio more pronounced.
The bottom-line is that step-up SIP is a good idea but its ability to create wealth is hampered by time value working against larger SIP commitments. That is something you need to remember while committing funds to a step-up SIP.