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Set yourself to benefit from compounding

Recently I wrote that a person aged 25 and earning $35,000 a year may accumulate $4 million in superannuation at age 65 just by relying on the employer compulsory contribution.

This resulted a flood of emails asking if I had made a mistake in the calculations as the outcome seemed too good to be true.

There was no mistake – it was just compound interest doing its work. To put it simply, how much you will have at the end of a given period depends on the time the money is invested and the rate you can achieve. If the term is short, the rate matters little, but as time lengthens it matters enormously.

To get an estimate of how much a 25-year-old could expect at age 65 we need to make certain assumptions. They are the rate of growth of salary, inflation, and a reasonable earning rate. In the example, I assumed inflation was 3% per annum, wages growth was 4% per annum, and the rate of return was inflation plus 7% (historically reasonable but perhaps a tad optimistic now). This gives a nominal return of 10% per annum. I also assumed the employer contribution would rise to 12% by 2020.

An important step for understanding the buying power of the $4 million is to convert those future dollars to today’s dollars. If inflation was 3% per annum, $4 million in 40 years would have a value of just $1,212,000 in today’s dollars. Yes, still a hefty sum, but doesn't sound nearly as much as $4 million.

Massive impact of term and earning rate

The big lesson here is the way the rate and the duration of the investment dramatically affect the end balance. Suppose a person invested $1,000 a month towards their retirement. If they started at 25 they would have $6.3 million at age 65 if they could achieve 10% per annum. However, the final sum would be just $2 million if they only achieved 6% per annum.

If a person waited until they were 45 to start the programme, and still managed to invest $1,000 a month they may have $760,000 at 10% and $462,000 at 6%. Because the term is much shorter the lower earning rate does not have such a dramatic effect.

The importance of getting the best return on your superannuation is particularly important now that employer contributions are not going to increase as fast as originally planned.  Recently the media have been focusing on the effect a reduction in the employer contribution would have on their final balance, but it’s small bikkies in the scheme of things. For a person earning $80,000 a year the net employer contribution after the 15% entry tax would be $6,460 at 9.5% of salary and $8,160 at 12% of salary. The difference is just $1700 a year.

Engage with your super early

I regularly receive emails from young people whose superannuation is all in the capital stable or balanced area. This is inappropriate for anybody under 50. To make matters worse the majority of SMSFs have no exposure to international funds at all. Obviously the trustees have never bothered to check out funds like Magellan (Global Fund) and Platinum (International Fund), which have strong track records of delivering good returns.

A major finding of the Cooper Review into superannuation was that 80% of Australians were ‘disengaged with their super’. If you find yourselves in that 80%, my advice to you is to start to get engaged. You've just seen how a small difference in the rate of return or starting earlier can make a huge difference to the amount you will have when you retire.

 

Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. His website is www.noelwhittaker.com.au.

1 Comments
Ramani
October 31, 2014

That humanity needs to be reminded time and again about compound interest is a telling commentary on our collective ability to ignore the basics. Like gravity, compounding works its impact in an agnostic way - just as Noel points out the merits of compounding when you are a saver, the downside when you are a borrower and allow interest to accumulate is equally relentless. The disengaged, the negligent, the downright careless and the unfortunates fallen on hard times find this to their personal and family cost.

We have successfully transformed our inability into extreme forms of reaction, including pejoratives such as 'usury'.

On the practical side, deposit-takers and lenders have arrogated to themselves the mathematical consequences of compounding: thus a five year compounded deposit boasts of a stellar equivalent simple interest rate achieved, forgetting that each interest instalment has also been deposited till residual maturity. Equally, the interest 'saved' by borrower by increasing the frequency of repayment is often advertised almost as if the lender is doing a favour. It would help to remember that the ultimate saving of interest is achieved by making the principal or duration zero: don't borrow, or repay on the date of borrowing!

Something many find revealing is compound growth is more natural than simple rate of growth. If we accept that something will grow by a set percentage at a defined frequency, it must follow that the new growth will also grow likewise. Simple rate of growth denies further growth to the new offshoot, and is hence artificial. Think of a small plant, and this will dawn on us.

 

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