Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 48

The effect of real wage changes on retirement incomes

The annualised inflation rate reached 2.7% at the end of the December 2013 quarter, which was higher than expected. Shortly after the inflation figure was announced, The Australian Financial Review ran a headline, Real wages ‘have to fall’, a view put forward by a number of economists and business leaders. This argument was given publicity despite modest real wage growth over the last year. Wages grew in real terms by only around 0.5% in the 12 months to 30 September 2013.

The topic of real wage growth often prompts the airing of strongly held views about global competitiveness and long term economic prospects. Less discussed is the fact that real wage growth directly impacts retirement outcomes.

Real wages and competitiveness

Real wage growth (that is, pay rises in excess of inflation) can be good or bad. High real wage growth is dangerous if it does not reflect productivity gains. It may be dangerous even if it does. For example, productivity improvement in a specific industry might be driven through a technology available worldwide, but some competing countries may use the technology to reduce product cost rather than increase wages.

Real wage growth has ramifications for long term international competitiveness. If Australian real wages are higher than in countries providing competing goods and  services, then logic suggests we will lose business to those countries. In the short term, real wage growth is pleasurable as we have more to spend now. However it is likely to catch up with us if it is not supported by productivity growth as our country loses competitiveness. This could affect us in many ways – for example, a sustained period of our businesses struggling to compete globally, poor stock market performance, a prolonged period of adjustment to future wage growth and employment, and a weaker dollar and associated reduction in purchasing power. However these things are difficult to predict and put a timeframe around.

Replacement ratios in retirement

Real wage growth directly affects retirement outcomes in a couple of ways: dollar outcomes and replacement rates. I like the concept of replacement rates: the ratio of post-retirement cash flow to pre-retirement income. I adjust the pre-retirement income for tax and savings, so what we have is a ratio of how much we have to spend in retirement versus consumption when working. To summarise:

DB 7Feb Ratio

DB 7Feb Ratio

A high replacement ratio would be desirable, but forecasting replacement ratio outcomes is complex and difficult. Treasury has a huge model and some industry participants also have advanced ones. I developed one for a thesis and have written about it in Cuffelinks (see May 16, 2013 issue). Importantly, projected outcomes will differ across the population. I follow Treasury’s approach and use forecasts for different income quartiles.

These are the numbers I produced at the end of 2011:

Earnings Multiple

0.75

 

1.0

 

1.5

 

2.5

 


Average Replacement Rate Ratio

81.1%

 

68.4%

 

56.0%

 

61.0%

 




Table 1: Projected replacement rate outcomes. Note ‘Earnings Multiple’ refers to income as a multiple of AWOTE (a measure of average earnings across the population).

Table 1 shows that replacement rates look higher for low income earners compared to higher income earners. This is because they receive the age pension but their current incomes are low and to live on even less would be difficult. Higher earners experience lower replacement rates but they can probably live with this as their pre-retirement incomes are higher.

Note the slight quirk here. Very high (top quartile) earners have a higher expected replacement rate ratio than the third tier. Why? In my modelling, you have to earn a very high income to save beyond paying down your mortgage, and the third (second top) tier earners run the risk of feeling wealthy but experiencing a retirement outcome well below their expectations.

Wages and retirement income

Real wage growth has two direct effects on retirement outcomes.

First, it pushes up age pension payments, which are indexed to whichever is the greater: wage growth, inflation or the age pensioners living cost index. Wage growth is expected to be the highest and this pushes up pensions. About 80% of the population is forecast to receive at least a part age pension at some point, and of these, half will receive full pensions.

The second effect is the level of wages against which we compare our outcomes (the main part of the denominator in the replacement rate equation). If we experience high real wage growth then, all else being equal, retirement savings and hence retirement income potential will grow at a slower rate relative to wages.

People will be affected in different ways, depending on incomes. The table below explains some of the sensitivities.

Earnings Multiple

0.75

 

1.0

 

1.5

 

2.5

 


Real Wages +0.5% pa

0.8%

 

0.5%

 

0.0%

 

-2.5%

 


Real Wages -0.5% pa

-1.1%

 

-0.4%

 

0.7%

 

2.7%

 




Table 2: Altered real wage growth levels (base case assumption of real wage growth was 1.5% pa) and associated changes to projected replacement rate outcomes.

Table 2 shows that low income earners will experience better replacement rate outcomes if real wage growth is high, because of higher age pensions. Their replacement rate would be just under 1% higher. It is the top quartile income earners who lose out if real wage growth is high: their replacement rate would be around 2.5% lower. Note, though, that this is relative to their working life income levels, which would be higher under a high real wage growth scenario, so don’t worry too much for the higher income earners.

To sum up, increasing real wages doesn’t seem a bad scenario in terms of the direct impact on retirement outcomes. Don’t forget however that higher age pensions (resulting from higher real wage growth) are funded by the government and it must raise this money from somewhere.

This analysis only considers the direct effects of changes to real wage growth, but there could be secondary effects. For instance what if high real wage growth led to loss of competitiveness and a prolonged period of poor market performance? While this is a large call to make, it is interesting to consider the impact.

Earnings Multiple

0.75

 

1.0

 

1.5

 

2.5

 


Investment Returns +0.5% pa

3.3%

 

3.3%

 

4.6%

 

7.6%

 


Investment Returns -0.5% pa

-3.0%

 

-2.8%

 

-3.5%

 

-6.2%

 




Table 3: Altered long term investment returns (base case assumption of long term investment returns was CPI + 4.75% pa) and projected changes to replacement rate outcomes.

Table 3 shows that changes to investment return assumptions have a much greater impact on replacement rate outcomes than changes to real wage growth. Your super fund may actively manage this risk in its investment strategy. In fact, some large super funds benefited last year from shifting allocations from Australian shares into global equities.

In summary, real wage growth does pose a direct threat to retirement financial outcomes, but it is the indirect effects, particularly around international competitiveness and investment returns, lurking in the shadows that create greater concern.

David Bell’s independent advisory business is St Davids Rd Advisory. David is working towards a PhD at University of NSW.

RELATED ARTICLES

Super performance test will destroy viability of some funds

Three retirement checks for when you have enough

Retirement adequacy: COVID means we need to work longer

banner

Most viewed in recent weeks

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Anton in 2006 v 2022, it's deja vu (all over again)

What was bothering markets in 2006? Try the end of cheap money, bond yields rising, high energy prices and record high commodity prices feeding inflation. Who says these are 'unprecedented' times? It's 2006 v 2022.

Latest Updates

Superannuation

Superannuation: a 30+ year journey but now stop fiddling

Few people have been closer to superannuation policy over the years than Noel Whittaker, especially when he established his eponymous financial planning business. He takes us on a quick guided tour.

Survey: share your retirement experiences

All Baby Boomers are now over 55 and many are either in retirement or thinking about a transition from work. But what is retirement like? Is it the golden years or a drag? Do you have tips for making the most of it?

Interviews

Time for value as ‘promise generators’ fail to deliver

A $28 billion global manager still sees far more potential in value than growth stocks, believes energy stocks are undervalued including an Australian company, and describes the need for resilience in investing.

Superannuation

Paul Keating's long-term plans for super and imputation

Paul Keating not only designed compulsory superannuation but in the 30 years since its introduction, he has maintained the rage. Here are highlights of three articles on SG's origins and two more recent interviews.

Fixed interest

On interest rates and credit, do you feel the need for speed?

Central bank support for credit and equity markets is reversing, which has led to wider spreads and higher rates. But what does that mean and is it time to jump at higher rates or do they have some way to go?

Investment strategies

Death notices for the 60/40 portfolio are premature

Pundits have once again declared the death of the 60% stock/40% bond portfolio amid sharp declines in both stock and bond prices. Based on history, balanced portfolios are apt to prove the naysayers wrong, again.

Exchange traded products

ETFs and the eight biggest worries in index investing

Both passive investing and ETFs have withstood criticism as their popularity has grown. They have been blamed for causing bubbles, distorting the market, and concentrating share ownership. Are any of these criticisms valid?

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.