- February 28, 2017
- Category: Investments
Investing a huge lump sum amount is a big task. It is not just about how to split it but also how to create a regular income out of it. While investing a lump sum, the market timing aspect also comes into picture. If the call goes wrong, there is an opportunity loss for the investor to earn better returns. No, I am not talking about the stock markets here. I am referring to fixed income options like bank deposits, recurring deposits, etc. You may think that these must be safe investment options but there are various risks associated with them. Let us understand with the help of an example:
Mr.A invests Rs.30 lakh in a 3 year fixed deposit yielding 8.5% p.a. After 1 year, the interest rates go upto 9.5% and after another 6 months to 10% p.a. With his existing deposit earning low interest rate, Mr.A decides to break the fixed deposit mid-way. By doing so, he not only loses on the interest but also pays a penalty for early withdrawal. In another scenario, if interest rates go down after the maturity of his fixed deposit, he would be forced to reinvest at a lower rate.
The investing dilemma with Deposits:
Everyone strives to earn better rates on fixed deposits. But there is reinvestment risk which one cannot avoid. Interest rates have a long cycle of peaking up and bottoming down, they do not change overnight and neither can one predict their direction. So, one needs to stay invested for a longer period. But here, again, one compromises on liquidity. So how does one plan investments in an efficient manner in debt options to lower reinvestment risk and liquidity risk?
There is a way to balance the above situation and it is called Laddering. It is specifically applicable to fixed income options like bank deposits, recurring deposits, etc.
What is Income Laddering?
It can be used to create a reliable income stream out of a lump sum amount on hand with low risk. The idea is to create an investment ladder i.e., divide a lump sum amount into various blocks, park them in fixed income options and then spread them across various maturities to avail a guaranteed amount at the desired regular intervals.
Let us understand this better with the illustration below:
Taking forward the above example, suppose Mr.A does not invest the entire Rs.30 lakh lump sum assuming he will probably not require the entire amount to spend in one shot. He is advised to divide the amount into 6 equal blocks, i.e., Rs.5 lakh each. To create an income ladder, he keeps aside Rs.5 lakh for the current annual requirement. Then he invests Rs.5 lakh in a 1 year fixed deposit, another Rs.5 lakh in a 2-year deposit and so on till he invests the last 6th block in a 5-year deposit. After the maturity of the 1-year deposit, it can be reinvested in a 5-year deposit to create the sixth rung. When the 2-year deposit matures, it can be reinvested in a 5-year deposit for funds required in the seventh year and so on. The amount received on maturity can thus be reinvested every year to lengthen the ladder as per requirement and can also be utilised for immediate cash needs. This can be visually understood from the image above in the mind map:
Advantages of Laddering:
- Helps minimise reinvestment risk: This strategy helps to minimise the reinvestment risk especially in a rising interest rate scenario. An investor does not want to feel compelled to break his deposits and pay penalty on early withdrawal to reap the benefit of rising interest rates. Laddering helps to use the periodic maturity proceeds to reinvest at least a part of the funds at a higher rate. Even in a falling rate scenario, the overall return on the corpus will still be higher than the prevailing rate of return as there would be blocks invested at higher rates earlier.
- Ensures Liquidity: Any investment needs to have a window of liquidity allowing investor to access funds without the fear of penalties. Through the income laddering strategy, an investor can plan deposits at various intervals and access funds at different points of maturity without breaking or closing his deposits.
It works best for retirees who have the major challenge of deploying their huge retirement funds in various investment options. Their primary concerns are availing steady returns and liquidity during retirement. The laddering strategy serves this dual purpose. A retiree through this strategy can invest a big lump sum amount to avail steady returns by minimising the reinvestment risk and create a reliable income stream every year.
Investors wanting to create a corpus for short term goals can also take advantage of the laddering strategy. Suppose, an investor needs to pay for his child’s college fees after 3 years when he turns 18. He can create a 3-year ladder of fixed deposits when the child is 15 years. There can be other situations too when an individual may need a regular income, bearing in mind the liquidity aspect. For example, a person planning to start his own business, a working lady who is expecting and may be taking a sabbatical from work, an individual not having a steady job and an erratic income stream, a chronic illness which would require huge medical costs over a period of time, etc. The tenure of laddering will depend upon the financial situation and liquidity requirement of every individual.
To conclude, while no fixed income option investment is completely risk free, laddering strategy is anefficient way to plan and execute investments to mitigate risks.