No mistake, just compound interest
RECENTLY I wrote that a person aged 25, 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 what is 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%. This gives a nominal return of 10% per annum. I also assumed the employer contribution would rise to 12% by 2020.
The next step is to covert those future dollars to todays dollars. If inflation was 3% per annum, $4 million in in 40 years would have a value of just $1,212,000 in todays dollars. Yes, it still a hefty sum, but doesn't sound nearly as much as $4 million.
The big lesson here is the way the rate and the duration of the investment dramatically affect the end balance. Suppose a person invested $1000 a month toward 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 $1000 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.
A major finding of the Cooper enquiry into superannuation was that 80% of Australians were "disengaged with this 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 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. Email: firstname.lastname@example.org.