In a country with compulsory superannuation it is worth asking how much of each paycheck does the average Australian need to save for retirement. Is it the current compulsory guarantee rate of 11.50%? Does it require additional concessional or non-concessional contributions? And if so, how much?

I think super being compulsory is a good thing. Others disagree. My personal perspective is shaped by my experience in the US where many people fail to take advantage of the significant tax advantages of retirement accounts and struggle more than they need to in retirement.

One downside of the compulsory aspect of super is the evidence that many Australians are disengaged from their own retirement outcomes. At least until it is too late. For instance, 90% of AustralianSuper members are in the balanced (and default MySuper) option which allocates ~24% to defensive assets.

I can’t speak to every one of those members invested in a balanced option but with an average age of 42 for all members I believe that is too conservative for many of those investors. Especially if they don’t make additional contributions on top of the super guarantee.

I think more than anything this data demonstrates that many Australians are apathetic about what it takes to achieve a good retirement outcome. My guess is this extends to how much needs to be saved. This is completely understandable. Our default condition as humans is procrastination. But I hope to open some eyes with this article.   

How much you should save for retirement?

The obvious answer is it depends. We all have different circumstances and factors like having a paid off house or the type of lifestyle each of us desires in retirement will influence how much we need to save. It also matters if there are other potential sources of retirement income from avenues like the age pension. Yet a common rule of thumb is that retirees should be able to replace 70% of their income in retirement. I will use that figure as a jumping off point and assume that you can only rely on super to do it. See this article for more detail on estimating how much you need to retire.

There are several factors that influence the size of your retirement nest egg. The amount you save matters which is the factor I will explore today. It also matters how high of a return you receive and the amount of time you save and invest.

As a baseline I am going to use the AustralianSuper balanced option. AustralianSuper is the largest super fund in Australian. Given that 90% of member are in the balanced option we can assume that more Australians are invested in this option than anything else. Over the last 10 years the annual return has been 8.07%. I will assume that same return is earned over the entire working life of my hypothetical retirement saver. I will explore the impact of different levels of return later.

It is irrelevant how much my hypothetical retirement saver makes as I will use the income replacement rate as the mechanism to judge success. I used the round number of $100,000 as a starting salary to make things easy on myself. The same model will apply to any salary.

After the 15% tax on super contributions this equates to an annual contribution of $9,775. This saver will spend 40 years in the workforce before retiring and I’m assuming wages will increase at a 3% annual rate to keep up with inflation. I will calculate the income replacement rate at both the rule of thumb 4% withdrawal rate and the 5% withdrawal rate which is mandated by the ATO after age 65.

Our hypothetical retirement saver was able to replace about 50% of their income at a 4% withdrawal rate and 63% at a 5% withdrawal rate. This isn’t a great outcome.

The issue is not so much the distance from the 70% goal but the underlying assumptions built into the model. The first assumption is that somebody stays continually employed and continually makes contributions to super for 40 consecutive years. This is not reflective of reality for a lot of people. It means never having a period of unemployment. It means never taking time off to care for a child beyond the paid parental leave period or to take care of an elderly parent. It means no periods of part-time work. It means never paying capital gains tax on any of the investments in super.

Ignoring all of these assumptions it would take contributions of 16% to reach a 70% replacement rate at a 4% withdrawal rate and 12.85% at a 5% withdrawal rate.

What if returns are higher?

My next hypothetical retirement saver has invested in a high growth option. Once again, I’m using the returns from AustralianSuper over the last 10 years and projecting that over a 40 year working life. In this case the return is 9.04%. All other assumptions are the same.

You may think that a return of a little less than 1% more a year isn’t a lot. You are wrong. Over the long-term even small differences in returns can make a big difference. That is why it is so important to focus on anything that detracts from returns – fees, transaction costs and taxes to name just a few.

In this case at a 4% withdrawal rate the hypothetical high growth retirement saver has replaced close to 64% of income. At a 5% withdrawal rate the target has been exceeded with just under 80% of salary replaced. Much better. At the 4% withdrawal rate it would take contributions of 12.60% to reach 70%.

The lesson here for long-term investors is that asset allocation matters. It is the largest contributor to the returns you achieve. I’m shocked that 90% of AustralianSuper’s members are in the balanced option. For many of these people the allocation to defensive assets in the balanced fund is too high to achieve the return needed to meet their goals.  

What return are you actually getting?

My assumption in the scenarios I ran is that the hypothetical retirement saver was getting a steady return that matched the returns from two pre-mixed options at Australia’s largest super fund.

As someone who writes about personal finance these are the assumptions I make in my day-to-day job. I write about historic returns or project returns into the future to show the impact of saving and investing and the power of compounding. This is important for people to understand because consistent saving and investing has the power to transform lives.

Yet the fact remains that many investors don’t achieve those returns. And this isn’t a question of active or passive or an indictment of anyone’s investment strategy. I think there are lots of different approaches that work. The problem is that many investors continually squander the largess of the incredible wealth generating engine that financial markets represent.

Investors do this because they don’t have goals and an investment strategy to achieve them. Investors do this because they pay unnecessary fees. It happens because investors turn their portfolio over too much and pay too much in taxes and transaction costs as a result.

Some investors do this because they are too confident for their own good and think they can nimbly navigate the random – yes, random – short-term movements of the market. Other investors do this because they are too conservative and don’t understand the real risk to the life they want to live is not their portfolio going down temporarily but not investing in the first place.

This is not judgmental. Investing is hard. Really hard. As a society we have continually put more of the onus on individuals to sort out their own financial future without providing basic education in how to do that. And unsurprisingly we have a financially illiterate society. We don’t hand out Dostoevsky to year one students learning to read and tell them to figure it out. Yet we are perfectly comfortable handing over some credit cards and a super account to someone on their first day of work.

This was a bit of a rant. But anyone that reads this and is saving money should make sure they aren’t negating this sacrifice with unnecessarily low returns. My colleague Shani wrote a great article on the real - inflation adjusted - returns that investors actually end up with. Read the article for the detail but here is the chart she included looking at a hypothetical 10% return. Don’t be this person.

Retrun reduction

Final thoughts

My own personal perspective is that to have a comfortable retirement you should save more than 15% of your paycheck when you are young. And this is to meet the basic standards of retirement. If you want a better outcome you need to save more. If you want something different you need to do something different. That is just life.

I understand how challenging this is. I know there is a cost-of-living crisis going on. I’m living through it. Yet that doesn’t change the fact that I don’t think the current super guarantee is enough.

Life is full of unknowns. You don’t know what returns you will achieve over your lifetime. You don’t know how much time you will want / need to take off during your career. You don’t know how long you will be able to work full time in your chosen field. Control what you can control. That is how much you save and limiting all things that reduce the returns you achieve.

You don’t buy insurance because you expect to get in a car accident or have your house burn down. You buy it to protect against the unknowns. Saving and investing also protects against the unknowns – however, unlike insurance there is a pay-off if the risks don’t come to fruition. You don’t get the money you paid for insurance back if nothing bad happens. If you save and invest a little more than the bare minimum you get to keep and spend anything extra later in life. Seems like a sensible choice with minimal downside.

I would love to hear your thoughts. Email me at [email protected]

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