Building a better retirement nest egg: Part 1 - Factors that influence retirement savings
In 1970 the average person in the OECD spent two years in retirement. By 2012 this figure had increased to 15 years. Many workers in the developed world now spend as much of their life out of the workforce as they do in it. Given this change, saving enough for retirement is a pressing global issue.
In Australia, as people live longer than ever before there has been a marked increase in the number of people who are delaying retirement to the age of 70 or beyond, partly reflecting changes to the qualification age for the age pension.
Australian Bureau of Statistics’ (ABS) data on retirement and retirement intentions observed that 47% of people already retired are dependent on a government pension or allowance as their main source of income1. The corresponding increase in the burden on public finances, and subsequent moderation of government spending on the age pension, has made increasing the size of private retirement savings a key priority for both the government and individuals approaching retirement.
This article, the first in a series of two, looks at the factors that influence retirement savings by analysing Australian workers’ experience since the compulsory superannuation system was adopted. In the second part we explore ways to increase super account balances and achieve a higher income after leaving the workforce.
The analysis of the factors driving the size of the savings balances at retirement is based on a standard worker who works fulltime from age 20 and receives average earnings that grow at the historic wage growth rate of 3.5% p.a. (as measured by the Australian Bureau of Statistics). It’s assumed the worker invests in a traditional balanced fund, a proxy for which is provided by the average of the Morningstar Growth Category.
Based on the experience of Australians over the past 25 years the size of a worker’s savings at retirement is overwhelming dictated by two things: how much they contribute and the investment’s return rate.
For the average worker, approximately 60% of the retirement nest egg is attributable to investment returns, with the other 40% directly attributed to contributions to savings. The vast majority (>90%) of returns are associated with the asset allocation (risk profile) chosen by the worker with only a small percentage attributable to active management.
Sequence of contributions: The importance of early tax-effective contributions
Not all contributions are equal when it comes to saving for retirement. Using the investor described above, due to the compounding of returns, a dollar contributed into savings at age 20 grows in real terms to be worth just over $6 at retirement.
The magnitude of this compounding is greatly affected by tax treatment of returns. For the same individual with the same returns, subject to a 30% tax rate, a dollar saved at age 20 only grows to be worth $2.60 in real terms at retirement. Compounding returns overtime disproportionately benefit individuals who contribute to their retirement savings early in their careers and utilise tax effective saving vehicles.
While young people will benefit the most from a tax-effective savings vehicle, this gain needs to be considered against the cost of losing access to savings for a longer period of time. So making contributions to retirement savings early in a career is important.
Individuals who take long periods of time away from the workforce early in their career have significantly less money at retirement than those who remain employed while they are young. A person who leaves the workforce for a decade at 25 is forecast to retire with almost 30% less than a worker who remains in the workforce. But if the same period of absence from work had begun at age 50 the relative shortfall would be approximately 15%. People who take time out of the workforce early in the careers perhaps owing to family commitments or to pursue studies are expected to have retirement savings significantly lower than peers who stay employed. Catching up with these peers is difficult it’s difficult to make up for early missed contributions. They need also to make additional contributions to make up for the compounding tax-advantaged investment returns their peers received.
Investment returns: The importance of asset allocation
Investment returns make up approximately 60% of retirement savings so it’s important to understand what drives this. The most significant factor affecting the magnitude of returns is the asset allocation/risk profile of the investments.
Investors with a higher tolerance for risk, that is greater exposure to growth assets, enjoy higher returns over the long term.
AMP Capital analysis reveals 97% of all returns for a growth investor are driven by asset allocation while on average only 3% can be attributed to active management2 . Individuals can increase the proportion of their retirement savings attributable to returns by choosing appropriate asset allocation and good active managers. If real investment returns rise from 3.5%to 4.5% per annum on their savings they will have a nest egg at retirement that is 31% larger, with 70% attributable to investment returns versus 60% at the lower real return rate.
To put this into context, since 1990 an individual who chose an aggressive risk profile (more than 90% in growth assets) has received investment returns 2.7% p.a. higher, and a super balance 300% larger, than a risk-averse investor who chose cash. So appropriately selecting assets active managers can help investors reduce their reliance on direct contributions to their super fund and increase reliance on correct asset allocation. Reliance on direct contributions is further reduced if workers continue to stay appropriately invested after reaching retirement.
1. Retirement and retirement intentions, Australia, July 2014 to June 2015, Australian Bureau of Statistics, Cat No: 6238.0
2. AMP Capital, Morningstar