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Why 10/30/60 is no longer the rule

The 10/30/60 rule has become one of the stalwarts of investment advice in superannuation. The rule was developed by Don Ezra with his colleagues at Russell investments, at a time when double-digit equity return expectations were common.

Ezra explains through this rule that, on average, for every dollar of income spent in retirement (from retirement savings), 10 cents came from contributions, 30 cents was from investment earnings in the accumulation phase, and 60 cents was earned in retirement while capital was being drawn down. It’s a stunning idea.

Sadly, today it’s no longer true.

Low returns require higher contributions

In the first version for defined benefit funds in 1989, he noted that 20% of payments typically came from contributions, which could fall to 10% when returns were high. In today’s low rate environment, high investment return assumptions are unrealistic. Ezra himself noted this back in 2011 when he suggested that a ‘15/30/55’ rule would be more appropriate. Without the higher returns, more money needs to be contributed to produce income later in life.

Indeed, in the Australian context, using averages of 6% net returns and 2.5% average inflation since the start of the superannuation guarantee in 1992, the result would be a 15/31/54 split, close to Ezra’s modified rule.

This is a great example of the power of compound interest and it highlights the leverage provided by contributing early and regularly to super. It highlights the benefit of (and need for) high returns in retirement. In practice, it is more to do with ‘money illusion’ and the fact that inflation skews the way we count the money.

For example, let’s assume that the return environment will be broadly similar to the last 25 years, with returns at 6% with inflation at 2.5%, or the 15/31/54 rule. ‘Notional’ is the key word here because the 15 cents to the 25-year-old who makes their first contribution is worth a lot more than the 15 cents they spend as a retired 80-year-old, 55 years later. Treating the two amounts as equivalent is where we fall for the money illusion.

It is simple to model the rule if returns are assumed constant. The rule still ‘works’ when they are not, but only on average. A bad sequence of returns can prematurely end the income, producing something like 15/31/21, and retirees feeling seriously short-changed.

Ezra’s rule depends on the impact of inflation. But what happens when you take inflation out of the equation?


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Keeping it real by thirds

In real terms, the rule is starkly different. With a real return of 3.5% (and real salary growth of 1% also in line with historical achievements), the rule becomes 32/33/35, or roughly a third, a third, a third. That’s right - in real terms, each component makes an equal contribution to the end result. Rule 101 of pension finance is to think in terms of today’s dollars or real income in the future. In other words, we should think about our retirement income through the lens of today’s purchasing power. ASIC requires that forecasts of retirement income streams be in today’s dollars in order to take into account the assumed change in the cost of living over the relevant period.

Maintaining the balance

The lop-sided nature of a 10/30/60 rule makes it seem that contributions are not really significant and that if all else has failed, a retiree will be able to make up for everything if they can just get high returns in retirement. While some like to imagine retirees sitting on a beach (or a yacht) while their investments do the hard work, this is probably as close to reality as a Monty Python skit. As the Black Knight in Holy Grail found out, things do not always end well.

In the real world, the final outcome needs a balance. Money needs to be saved (contributed to super) to build a decent savings pot, and investing early in super makes sense due to compounding. Investment returns needs to be generated in both the accumulation and the retirement phases. The difference will be in the way risks are managed. In the accumulation phase, the investor has the time to recover from swings in the market. In retirement, that luxury is diminished and the risk of a bad sequence means that retirees have to balance the need for return against managing the risks.


Source: Pinterest (ankeshkothari.com)

Just like the optical illusion replicated here, inflation can skew our perception of the relative size of objects that are equal.

What does all this mean for superannuation funds and retirees? In real terms, with good investment returns, workers can expect to spend $3 in retirement for each dollar they contribute while working.

 

Aaron Minney is Head of Retirement Income Research at Challenger Limited. This article is for general educational purposes and does not consider the specific needs of any investor.

 

8 Comments
John
June 26, 2020

The Australia 10Y Government Bond has a 0.879% yield. 20Y is 1.502%, 30Y is 1.710%. Unless buyers of these bonds are stupid (unlikely) money will remain insanely cheap until death for any current retiree. This suggests the economy is likely to remain depressed for 30 years. Consequently, investment returns are unlikely to average anywhere near historical 6% levels. Time to tell your kids there will be no inheritance.

John
June 26, 2020

The Australia 10Y Government Bond has a 0.879% yield. 20Y is 1.502%, 30Y is 1.710%. Unless buyers of these bonds are stupid (unlikely) money will remain insanely cheap until death for any current retiree. This suggests the economy is likely to remain depressed for 30 years. Consequently, investment returns are unlikely to average anywhere near historical 6% levels. Time to tell your kids there will be no inheritance.

Justin Ahrens
June 25, 2017

Great article; it highlights that there is no 'set it and forget it' mode, and also that individuals need to pay attention to their investments, need quality advice, and need to educate themselves about this topic - they don't need to be experts, but certainly need to be able to hold their own in the conversation.

Geoff Warren
June 23, 2017

Great article by Aaron, and a pertinent reminder that care needs to be taken in interpreting output from any model which depends on the set-up and assumptions. The point about real versus nominal investment returns is a substantial one. I want to add some context about the 10/30/60 research from the perspective of a Russell alumnus.
First, this analysis was never meant to be taken literally. It was designed to make one point with some impact: investment returns really matter a lot for retirement outcomes, so don't get too carried away focusing only on contributions. Translating to the current context, this would amount to saying that the question of whether a SGL of 9.5% is sufficient for retirement adequacy may not be as important as the returns that the markets will deliver going froward.
Second, an (overly modest) Don Ezra bucks up when you refer to 10/30/60 as "his" rule. The genesis is a Russell paper dated January 2008 by Matt Smith and Bob Collie. The press release appears at: http://www.prweb.com/releases/investment/russell/prweb974204.htm. Nevertheless, this paper did acknowledge Don for the original concept about the relative importance of investment returns, which arose when writing about defined benefit funds in 1989 (which he put at about 80%).

Garry M
June 23, 2017

It strikes me that superannuation policy was introduced in Australia in a high inflation environment and the incentives given to save were in part aimed at encouraging people to spend less on current expenditure.
We have now been in a low inflation era for quite some time and may well remain that way for a bit longer,yet I suspect policy makers are still thinking how to constrain retirement savings portfolios within this inflation mindset(i.e. still in the 10/30/60 era).
Instead of encouraging current consumption and sensible long term saving of a quantum required to meet the 33/33/33 to deal with lower nominal growth and people living longer in retirement,we have a situation of no confidence in spending more on current items(other than punting on real estate) and no capacity or real incentive to invest more in long term savings because of the threat that these will be taxed/constrained further by future governments.

Peter Vann
June 22, 2017

In any event, if you partially retire from full time work and need to supplement income from paid work with drawings from your investments, super or other investments, then the method of analysis Aaron is discussing is still valid. Instead of using the usual simple starting retirement income profile of a fixed annual amount in real terms, one uses an income profile (again in real terms). In this case it will start with a lower portion and rise of and when one fully retires from paid work.
If fact any practical analysis of retirement expenditure should use income profiles changing through the drawdown phase,

Ashley
June 22, 2017

Retirement – wotz that? – does anybody really retire any more? The ‘retirement’ industry is stuck in the outdated idea of 100% work on Friday to zero work starting the next Monday for the rest of their lives. I’ve never met anybody who does that.

Rob
June 22, 2017

Ashley, I've met lots of people who do, or have done just that, myself included (provided your definition of "zero work" means zero paid work, not voluntary stuff or hobbies).

 

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