Working Australians receive a guaranteed portion of their wages or salaries as a super contribution each year. Self-employed Australians (hopefully) pay some of their own profits into super each year. So it would be tempting to think that it is these contributions that make up the bulk of our retirement savings. But, for most people, that’s not how it works. There’s a super secret and we want to let you in on it.
The money that we move into super, by way of concessional or non-concessional contributions, is undoubtedly important. But, for most people, if things go as we expect, it will be the investment earnings that these contributions make possible that will govern how much we end up with in retirement.
Recently, we got out our trusty spreadsheet and crunched some numbers, and the results were surprising. The vast majority of the money that we end up with in super comes from investment earnings.
This week, we will look at accumulating retirement benefits while you work. Next week, we will add to this and look at what happens to your super after you retire.
The best way to understand what we are saying is by using examples. Let’s use two quite conservative ones.
Example 1 is a person who starts work at the age of 20. People do not earn much in their 20s, and their starting wage is $35,000. This then increases by $5,000 a year until person 1 turns 30. At the age of 30, they start earning $90,000 and this remains their wage (with a 2% real wage increase each year) until you retire at age 60.
The employer makes the compulsory super contributions of 12% each year (this will be the compulsory amount from 2025, so we will use this in the assumption). The superfund then invests the money and achieves an average return equal to the inflation rate plus 6% (after-tax).
We can ignore inflation because we are using real wage growth and an inflation-adjusted earning rate. This is handy because it lets us compare amounts across the periods.
By the time person 1 turns 60, there will be around $1.776 million in super. Of this, just $526,000 will have been ‘contributed in.’ The remaining $1,250,000 that has been created by investment earnings. In this case, that represents 70% of the total amount person 1 has in super.
Now let’s look at person 2. Person 2 starts the same earns the same as above until they turn 30. They then take 15 years out of paid work to raise kids before returning half time and working until they are 60. The employer makes the same percentage super contributions and the superfund gets the same investment returns.
At the age of 60, person 2 only has $712,000 in super (reflecting that people – usually women – who take time out of paid work to do the unpaid work of raising kids end up with much less super). Of this, $162,000 came from contributions and $550,000 – or 77% – came from investment earnings.
So, for person 2, super contributions comprise even more of their total super.
The main message from these two examples is that the way that you invest your super will have an outsized impact on how wealthy you are when you retire. In example 1, an investment return of 6% mean that 70% of total retirement savings came from investment returns. In example 2, where time was spent out of the workforce, that figure rose to 77%.
If we tweak the earning rate, we can see the importance of maximising the rate of return. Let’s say you are the client and you are in a superfund that charges an extra 0.5% in annual fees. This reduces the after-tax earning rate in our example to 5.5% plus inflation. Your total retirement benefits at age 60 fall from $1.776 million to just $1.584 million. Yes, a 0.5% difference in annual earnings in almost $200,000 less by the time you turn 60.
This is the real take home message for us today: investment returns in super are extremely important. One of the best ways to increase the earning rate is to minimise the fees you pay your fund, because the effective earning rate is reduced by the fees you pay.
Next week, we will take a look at what happens to your super after you stop work. But for now – maximise those earnings!
