What returns do you need for a comfortable retirement?
The math behind your retirement outcomes is a critical piece of your financial plan. While many focus on how much to save, it's equally important to understand the investment returns required to reach your goals.
This article looks at the return side of the equation, figuring out what return is required for a comfortable retirement at different savings levels.
Defining a "Comfortable Retirement"
Before running the numbers, we need to consider what constitutes a "comfortable retirement." Ultimately, this is a personal calculation.
For the purposes of this analysis, we've assumed a comfortable retirement requires:
70% income replacement for those who rent or have a mortgage.
50% income replacement for those who own their house outright.
We also assume a 4% withdrawal rate in retirement and no other sources of retirement income (like the Age Pension) to keep the exercise focused purely on the impact of savings and returns.
Baseline Scenario: Before Tax
The first scenario assumes someone is in the workforce for 40 years with no career breaks, receiving 3% annual wage increases.
We modelled outcomes for savings rates from 11.5% (the compulsory super contribution) up to 20%, factoring in the 15% tax on super contributions. We modelled returns from 3% to 12% annually.
The chart below shows the results, with the percentage representing the level of income replacement achieved.
[Image: Chart from source 21 showing retirement income replacement based on return and savings rate, before tax]
The key lesson from this first chart is that earning low returns makes it almost impossible to save your way into a comfortable retirement. Even at a 6% annual return, you would need to save more than 20% annually to replace just 50% of your income.
This highlights a significant risk: being too conservative with your asset allocation over a long (40-year) time horizon.
What Happens When Taxes Come Into Play?
Super is a tax-advantaged environment, but it isn't tax-free. During the accumulation phase, income and capital gains are taxed (typically at 15%, with discounts for assets held over a year).
This tax drag is highly personal and hard to model perfectly. For this exercise, we've applied a reasonable estimate:
We reduced returns of 7%, 8%, and 9% by 0.50%.
We reduced returns of 10%, 11%, and 12% by 1.00%.
The following chart shows what happens to the outcomes once this tax drag is factored in.
[Image: Chart from source 45 showing retirement income replacement based on return and savings rate, after tax]
This is not a pretty picture. At the current compulsory super contribution rate of 11.5%, you would need 10% after-tax returns to hit a 50% income replacement rate. To get to a 70% replacement rate, a 12% annual return is required , which is an extremely difficult, if not impossible, target to sustain for 40 years.
To put this in perspective, many large industry super funds' high-growth options have returned between 9% and 10% over the last 10 years, and this was during a very strong period for markets.
Final Thoughts
Building wealth requires good habits informed by math. The conclusions from this analysis are straightforward.
If superannuation is your sole source of retirement funds, the math shows you likely need to do two things:
Earn returns that are higher than what a standard balanced option will typically deliver.
Save more than the compulsory super contribution rate.
Saving more and adopting a portfolio allocation appropriate for higher long-term returns (which may involve more volatility) are the habits the math is telling us to adopt.
The most important piece of advice is to remember that time is your biggest asset. Small changes to your savings rate and investment strategy made early in your career have a far bigger impact than large changes made later.
Source: https://www.morningstar.com.au/retirement/what-returns-do-you-need-for-a-comfortable-retirement
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