Future Focus: Should I stop salary sacrificing to my super?

The $3 million super cap is set to come into effect on 1 July. This has an immediate impact on wealthy retirees and pre-retirees. They will be taxed on earnings on their balance above $3 million in their superannuation accounts. This policy was sold as a tax on the wealthy. The cap however has a major flaw – it isn’t adjusted for inflation.

This directly contradicts the intent of the tax. As inflation and compounding take effect over time, more Australians will find themselves impacted. Over decades, those that never considered a $3 million balance within reach are absorbed into this group. Today, a $3 million account balance may seem unattainable. In 3 decades, it is the equivalent of a $1.45 million balance today.

This is not such a far reach for many younger investors that will be contributing for the whole of their working lives, as well as enjoying the impacts of compounding over 4 decades.

The projection assumes that future governments do not fix this flaw in our tax system. The question today is if investors should incorporate the tax into decisions about retirement.
The general rule with investing is to stick to the knowns – structure your portfolio around the current rules and refine as you go and things change. Avoid speculating on the change of regulations but ensure that you are prepared.

Many young people with high incomes will hit the superannuation cap if there are no reforms in the future. This has caused some investors to stop or limit voluntary contributions to their superannuation based on the tax.

For a 30 year old with $120,000 in their super, earning $150,000 (assuming no pay increases)* they will reach the super cap of $3,000,000 by 60. Any variation of this scenario – earning more, having a higher rate of return, salary sacrifice – will push you past the super cap threshold.

Super has been around for just over 30 years, and it has morphed into something completely different from when it was first established. There is no doubt super will morph again over the next 30 years.

How should investors approach this problem? Do you continue to salary sacrifice to a better retirement and hope that future governments offer respite? Do you pull back to see what happens?

I have a few suggestions for investors with long time horizons to approach this dilemma.

Build in margins

You don’t know what is going to happen in the next week let alone the next thirty years. Any projection that you’re making on your portfolio and what you’ll have at retirement involves a lot of assumptions.

Any extra contributions made while you are younger with a longer time to compound and build in a bigger buffer for inevitable bear markets.

Bear markets are part and parcel of investing. Our tendency for recency bias means that we are prone to forget how brutal bear markets can and have been.

This chart shows the S&P 500 over the last 90 years (Macrotrends). While markets tend to rise the timing and severity of bear markets can ruin your plan. The recovery from the crash in 1929 didn’t occur until over 20 years later. The GFC took 8 years. If this happens towards the end of your working life, that could mean the difference between just getting by and a comfortable retirement.

My colleague Mark LaMonica recently wrote about building resilience in your portfolio. He gave a great example of how sequencing risk can ruin the retirement plans of the most prepared investors.

You have three decades to invest during your working years. One decade will be a terrible time to invest and returns will be flat. One decade will be an average time to invest and returns will be 8% per year. One decade will be a great time to invest and returns will be 16% per year.

Over the 30-year period you will save and invest $10,000 a year. In what sequence would you place the decades? In every scenario the average return is the same. Mark simply switched the sequence of returns. The following chart shows the results.

The market tends to go through good periods and bad periods. When they occur during your life is random because it is based on when you are born and when you start investing. During the first decade of the 2000s the S&P 500 had a negative return. The next decade the return was 13.56% annually.

You may opt to build in margins earlier to take the hard work off your plate later, or you may decide to contribute to other financial goals.

Be more ambitious

It is difficult to plan around super and marginal tax rates in 30 years’ time. However, it is important to understand the implications of decisions using the current tax rates.

That will enable you to determine if you should start saving for goals outside of superannuation instead of salary sacrificing additional contributions into super.

Even with the additional tax on balances over $3 million, super is still a tax-efficient way to invest for your retirement.

Take two scenarios* - $4 million inside of super, or $3 million inside of super and $1 million outside of super. I’ve also included a scenario where the individual is in retirement, and they have the pension account at a 0% tax rate. In this scenario, the earnings on $200,000 is taxed at 30%.

I’ve previously outlined the steps to create a goal for passive income for a goal like travel. The theory applies regardless of the goal – you can estimate a capital base for passive income prior to retirement.

Investing outside of super means that you have much more flexibility about how you use it.

Just take the safe route

If your salary and compulsory contributions are pushing you past what you have assessed you need for your retirement, be happy and take the peace of mind.

Morningstar advocates for a goals-based investment approach. This is a structured approach that focuses on anchoring your investment portfolio to your financial goals. It has four steps:

Defining your goals
Calculating your required rate of return
Setting your asset allocation
Selecting your investments

The second step of the process gives you a number. This is the return you need to achieve from your investments to achieve your financial goals. If you extend the time horizon the return that you need to achieve your goal naturally goes down. The asset allocation mix for a required rate of return of 7% p.a. and 4% p.a. looks very different.

For a lower required return, you can change your asset allocation to reflect the lower amount of risk that you need to take in your portfolio. Why take on risk and volatility that you don’t need to? Investing is a means to an end. If you are on track for your retirement goal with a lower required rate of return, you can reduce the impact of swings in the market, or a prolonged bear market.

For many people having more than enough for your retirement seems like a dream scenario. This is very different problem form basing a decision for how much to save for retirement based on a cap placed by the government (which will likely change over three decades).

Regardless of whether you are going to realise the effects of the cap now or in thirty years, reassess how you see it. It is not a hard cap. You are still only paying a maximum of 30% on the earnings on the balance above $3 million.

The cap will start to become more of a rotten deal as time moves on and inflation reduces the purchasing power of our money. It means that the same situation with the 30-year-old above will result in getting taxed more on a balance of $1.4 million + in today’s dollars. That is different than paying the tax on $3 million today.

As investors we can’t just decide that legislation reform is inevitable – no matter how unfair it is or how much time for the government to catch up. Inflation adjustments for this cap aren’t included in the Budget. I’ve written before on how there’s quite a few gaps in the system that aren’t giving Aussies a fair go. The $3 million super tax may be added to the list if inflation adjustments don’t occur. Save outside of super. Invest for other goals. Increase your expectations for what you see your retirement being. These are not bad problems to have. This is the reward you get for starting early and having the benefit of time on your side.

*8% p.a. annual return, 12% super contributions

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