What returns do you need for a comfortable retirement?
The math behind your retirement outcomes.
I recently wrote an article on how much you need to save to have a comfortable retirement. I thought I would turn this around and look at the return side of things. This is my attempt to figure out what return is required to have a comfortable retirement at different savings levels.
Before going through this exercise I had to consider what constitutes a comfortable retirement. Ultimately that is up to each person. Previously I’ve outlined how to estimate how much you need to retire. Give it a shot.
For the purposes of this article I’ve assumed that a comfortable retirement requires the replacement of 70% of your income if you rent or have a mortgage and 50% of your income if you own your house outright. I’m assuming a 4% withdrawal rate in retirement and assuming no other sources of retirement income like the age pension.
This is not perfect. But I do think most people could have a comfortable retirement with those income replacement rates. More importantly, I think the lessons from this exercise for investors are applicable even if you quibble with some of my assumptions.
Baseline scenario
The first scenario I ran was somebody that is in the workforce for 40 years with no career breaks. I’ve assumed 3% annual increases in wages across the 40 years. I modeled out the outcomes from different levels of savings and different investment returns.
For savings rates I started at the compulsory super contribution of 11.5% and then modeled out increases of savings from 12% to 20% in one percent increments. For each of the contributions I’ve taken the 15% tax on super contributions into account.
For returns I started at a 3% annual return and went in one percent increments up to 12% annual returns.
The following chart shows the results with the percentage representing the level of income replacement given the savings rate and return. I’ve colour coded the combinations that meet the 50% threshold and the 70% threshold.
My first observation is that there are a lot of white cells which represent savings and return combinations that don’t meet either threshold. The initial lesson from this exercise is straightforward. If you earn low returns you can’t save your way into a comfortable retirement. The biggest risk to your retirement outcome is to be too conservative with your asset allocation.
Even if you earn a 6% annual return over 40 years you still need to save more than 20% annually to replace 50% of your income. At a 7% annual return you can’t save your way to a 70% income replacement unless you save more than 20% of your income.
The overall conclusion is that if you are trying to achieve a 50% income replacement rate at the current compulsory super contribution rate you need to earn at least a 9% annual return over 40 years. At a 70% income replacement rate the return jumps to 10% annually.
Unfortunately, these conclusions are fairly meaningless because I haven’t taken taxes into account. That is the next thing I need to model.
What happens when taxes come into play
Super is a tax advantaged way to save for retirement. It is not tax free. During the accumulation phase both income and capital gains are taxed at 15% in super. There is a capital gains discount for assets that are held for more than one year.
Taxes are extremely hard to model. There is the tax on income which varies based on what is in each individual portfolio and the amount of dividends and interest that are paid each year.
Then there are capital gains. They are generated based on your behaviour. If you switch pre-mixed options it will have tax consequences. If you have more control over your super through a SMSF or a member-direct option capital gains may be generated every time you sell a position. Additionally, any of the actions taken by a portfolio manager who is investing for you in an industry fund or through an ETF or fund may generate capitals gains.
The overarching point is that tax matters but is highly personal. I’ve made the following assumptions. To adjust the pre-tax returns I used in the first example I’ve reduced returns by .50% at the 7%, 8% and 9% levels. At the 10%, 11% and 12% level of returns I reduced returns by 1%. This is not perfect and I chose the simplicity of using round numbers even though I am reducing each return level by slightly different percentages. But I do think it is a reasonable estimate for the purposes of this exercise.
The following chart shows what happens to outcomes at the saving level and return combinations that achieved at least a 50% income replacement rate in the first scenario.
This is not a pretty picture. At the current compulsory super contribution rate of 11.50% you need 10% returns to hit a 50% income replacement rate. At a 70% income replacement rate an annual return of 12% is required.
That is next to impossible to do. If you can get a 12% annual return over 40 years you should quit your job and open a hedge fund. The following chart shows returns over the last 10 years for some of the largest industry super funds.
These are not all comparable options. The naming conventions and asset allocation is different across different super funds. Yet you can see the returns achieved over the last ten years. And this was in a very strong period for markets. For example, the iShares S&P 500 ETF IVV has ten-year returns (In AUD) of 16.35% and Vanguard Australian Shares VAS has a ten-year return of 8.27%.
Final thoughts
I read this social media post that said building wealth is 80% habits and 20% math. I don’t know if that is true and have no basis to suggest anything different. What I do know is that the habits need to be informed by math.
I’ve written a series of articles now where I have taken a spreadsheet and tried to show the ‘math’ behind these vague notions that tend to drive decision making. The last two I’ve written on retirement savings rates and returns. The conclusions are the same. If super is your sole source of retirement funds you need to do two things:
- Earn returns that are higher than what a balanced option will typically deliver
- Save more than the compulsory super contribution rate
Saving more money and ignoring a more volatile portfolio for higher long-term returns are the habits the math is telling us to take up. This may not be what you want to hear. We are all dealing with the cost-of-living crisis and saving more money is hard. Yet that is what the math is showing.
The one piece of advice I would add is from another spreadsheet article I wrote on compounding. Time is your biggest asset. Small changes to returns and savings rates made early have far bigger impacts than large changes made later. The impact from lower fees and lower taxes also compound. Always keep that front of mind.
Let me know what changes you’ve made to help your retirement outcomes. If you write me at [email protected] I will send you the spreadsheet so you can model out different scenarios for yourself.
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