Start early and use compound interest to build your retirement benefit

As the Government prepares the legislation for the May Budget changes to superannuation, it will be aware of the daily media coverage expressing the strong views from various (wealthy) parties. The poor presentation of the changes has led to unnecessary dissatisfaction with superannuation and an emphasis on tax rather than outcomes.

This is a side issue as most members ought to be seeking to maximise their investment returns as this has the greatest impact on their retirement income.

Our recent Insight Super ambitions: Can we get to $1.6 million-plus? received immense interest.

We have been asked a number of questions, including:

• Do those on salaries of $100,000 have the ability to save 25% of their income.
• Whether the earning rate (6.5%) was too high in the current low interest environment.
• Similarly, whether assumptions for CPI (2.5%) and wage inflation (4%) were too high.
• Whether the $1.6 million was inflated in the future so that it was equivalent to $1.6 million today (yes it was).
• Whether $1.6 million is sufficient for an adequate retirement income (it is but you can save more than this at concessional tax rates within and outside superannuation).
• Questioning the accuracy of the results (unfortunately, there was a glitch in the earnings rate we used).

Ability to save

The intent of the calculations was to evaluate whether someone could reach a balance of $1.6 million (the new tax-free cap for pensions) under the revised contribution caps. The analysis demonstrates that the balance can be achieved if the individual has the capacity and desire to save regularly from an early age.

We recognise that this disciplined savings regime is beyond the ability of more than 90% of the population. However, they wouldn’t have reached this threshold under the old system anyway.

We also note there was conservatism in the results as we assumed that individuals would start voluntary saving towards the target from age 40. Our examples showed results for a 40-year-old with a variety of balances from $100,000 to $250,000. In fact, those who are able to make the most contributions have much higher balances. The top 10% percent of the population at this age have balances over $200,000 and the top 1% have balances in excess of $400,000.

Long term assumptions

The earnings rate of 6.5% certainly looks high against current bond yields and it is hard to see further medium term growth in asset values from their current levels. However, current investment conditions are not normal and we expect there will eventually be an outbreak of inflation and a revision to normal economic and investment conditions. This could be a decade away though!

We have modified the assumptions to see the impact. We have dropped the long term earnings assumption to 6.0% and wages to 3.5% but left CPI at 2.0%. We also reduced fees to 0.75% (which is 25% below the current average but which will become the norm sooner than many realise).

We have also run numbers on a higher earnings rate of 7% which is what the large industry and public sector funds have earned over the last two decades. If they can do that again, the levels of required contributions will be much lower.

Start saving early to reach $1.6 million

We can now present revised figures which make corrections to the initial analysis¹ as well as re-running them on a lower earnings and inflation base.

As set out in Table 1 and Table 2 (values in today’s dollars), Rice Warner has prepared eight case studies of fund members aged 40 with an intention to retire at 67 (the future eligibility age for the Age Pension). Four of the members are currently earning $100,000 a year with the other four earning $250,000 a year (the only impact this has on the results, is the amount of tax paid on concessional contributions which will be double for the higher income earners). Their existing superannuation balances range from $100,000 to $250,000.

The modelling shows that irrespective of the proposed changes each of the fund members can save at least $1.6 million in superannuation – bringing contributions forward makes this much easier, given the Government’s proposed cap on amounts transferrable to a pension account.

Based on certain assumptions including an annual (long-term) fund earning rate of 6.0% and wage inflation of 3.5%, Rice Warner calculates that:

All fund members are able to reach the prescribed $1.6 million cap. However, in order to do this with conservative earnings, the member must fully utilise their concessional contribution allowance and make non-concessional contributions which range from $4,000 per annum to $19,000 per annum depending on their current financial situation.

Members with low balances who leave saving in superannuation to much later in life (say post 50) will struggle to accumulate a balance of $1.6 million by retirement.

Table 1 Middle-income Earner: $100,000 salary today – balance required to reach $1.6 million at retirement

* This figure is a flat fixed contribution each year.

Table 2 High-income Earner: $250,000 salary today

* This figure is a flat fixed contribution each year.

Compound interest saves the day

The recent productivity commission report notes that retirement incomes are generally 70% funded by net returns and 30% funded by contributions.

The outcome is very sensitive to the assumed earnings rate. Table 3 (values in today’s dollars) demonstrates that if the earnings rate were 1% higher, it would eliminate most (if not all) of the need for non-concessional contributions for the two scenarios considered.

Further, if a member is able to make a significant once-off non-concessional contribution in the immediate term this can reduce their total non-concession burden by over 25%.

Clearly, the most effective approach is to start saving early and to let compound interest to do the rest of the heavy lifting to get to $1.6 million. For, example a 25-year-old with no balance would only need concessional contributions of $20,300 p.a. in order to achieve a balance at retirement of $1.6 million. Of course, this is out of reach for many but those with very high incomes would be able to achieve it.

Table 3 Lump sum non-concessional contribution required today

Assumptions: Fund earning rate 6.0%, CPI 2.0%, wage inflation 3.5%.

Note:

• Government’s proposed $500,000 non-concessional cap and $1.6 million cap on pension accounts are indexed. Under Budget proposals, concessional contributions of higher-income earners will become liable for Division 293 tax.
• Concessional contributions are subject to tax at 15%, those earning over $250,000 in Adjusted Taxable Income will pay tax at a higher rate of 30%. Subsequently, for these members a contribution of $25,000 will only be $17,500 after tax

¹The actual earnings rate was erroneously set higher than the rate of 6.5% disclosed. This analysis therefore replaces the previous work.