The post will be about opportunity costs. Specifically, the opportunity cost of investing in Superannuation versus investment alternatives.
Given I have lately been sparse in my writings, this will be a long post, over 2 weeks, covering a range of options and circumstances, to try and be of use to the largest number of readers.
Charlie Munger has an interesting way to put opportunity cost into layman’s terms. He says “When you get married, you have to choose the best spouse you can find that will have you” he adds “The rest of life is the same damn way”, and he is absolutely correct, people fail to properly consider opportunity cost in investing.
As investors, unfortunately, we are always making investment decisions out of the annoyingly foggy windscreen, rather than the crystal clear rear-view mirror. We must take whatever small advantages avail themselves… I will examine ‘opportunity cost’ from a different perspective over this week and next, to determine how useful the ‘opportunity’ that exists for Australians under the current Superannuation system.
Superannuation is a massive advantage for Australian savers, and one which is very poorly exploited by most people I talk to. For many people, a sacrifice into Superannuation will be the best option available to them at virtually any time.
There are risks, of course, with superannuation – primarily around the potential changing of the rules. The current Superannuation is extraordinarily generous as I will explain, I would support changes that made it less generous (though they would hurt the current investment strategy my Wife and I employ), at the moment, the advantages are huge, and wider than they need to be to encourage prudent retirement saving.
I will talk about the opportunity across 3 income levels, to try to cover a broad cross-section of potential readers.
Superannuation contributions are split into two classes – Concessional and Non-Concessional. Concessional (‘before-tax’ contributions) are contributions from your earnings (Super guarantee or your own ‘salary sacrifice’) for which you will receive a tax deduction (in simple terms, you will not have to pay whatever the marginal rate you would otherwise have paid). Non-Concessional Contributions are contributions from your after tax wealth and are, not taxed entering the fund (unless you exceed some very large thresholds).
Concessional contributions are taxed at 15% (up to certain caps, in FY14 $30k for someone under 50 or $35k for someone over 50). Earnings in the accumulation phase are taxed at a maximum of 15%, including 10% on capital gains for assets held longer than 12 months. In practical terms, according to Wikipedia, “the actual average tax rate is typically around 6.5%”. For simplicity, I will use that tax rate in calculating tax on earnings through the ‘accumulation phase’ in the examples below. Once a superannuation account turns to pension phase, assets backing that pension are (generally) distributable tax-free.
One misconception is that lower paid workers can’t really benefit from the Superannuation system. With the caveat that persons earning less money will inevitably find it more difficult to save some of those funds, our first case study will be of a person earning minimum wage. Australian minimum wage is $16.87 per hour, so a person with a full-time minimum wage job will have earnings of $674.80 per week or $35,090 annually. We will assume our minimum wage earner can only work 30 hours per week and therefore earns $24,350 or thereabouts.
A person earning between $18,200 & $37,000 finds themselves taxed 19c on the dollar. We assume our minimum wage earner is extremely disciplined and is capable of saving $1,000, or about 4% annually out of their paltry income. In doing this, they have two savings options.
Option 1, they could earn their wage and save from their take home pay. After paying 19c tax on each dollar, they will have 81c left to invest.
Option 2, they could sacrifice that $1,000 they intend to save from their pre-tax salary (avoiding the 19c in tax) and send it to Superannuation. Now, Concessional contributions are ordinarily taxed at 15%, but for those earning less than $37,000, the Government will credit the first $500 back. Our minimum wage-earner will therefore be deploying 100c on the dollar into investments via Superannuation.
From their savings choices they have either $810 to invest, or $1,000 to invest, so in the first place, the decision to save into Superannuation has resulted in an immediate 23.46% gain (1000/810). For simplicity, we will assume their tax-rate remains constant (19% on dividend earnings in the investment held outside of Superannuation & 6.5% on the annual change in the Superannuation based investment). We assume further, they are 35 years old and manage to earn 8% per annum (4% from capital appreciation & 4% from fully franked dividends) with the portion remaining after tax reinvested each year. Finally, we assume they maintain their good discipline and leave both amounts untouched until 65 years of age.
Upon completion of the 30 year investment cycle, the $810 invested outside of Superannuation will have become about $10,540 under the assumptions used. The $1,000 invested via Superannuation will have become a little over $15,900. The more than 23% advantage has grown to an advantage exceeding 50% over the investment period. Through nothing more than the tax-advantages of Superannuation as the rules stand, the exact same decision (to forego $1,000 income) leads to a 50% better final outcome.
Should our highly disciplined minimum wage earner continue to make the same $1,000 sacrifice annually, option 1 would end up with a savings pool held outside of Superannuation (which, depending on our minimum wage-earner’s retirement income, they may have to pay some tax on earnings/gains) of over $123,000. Option 2 would generate nearly $167,000 of Superannuation wealth, free to be distributed as a tax-free pension. Bear in mind, those two amounts are entirely separate to any Superannuation Contribution Guarantee the subject would have put aside.
The catch of course is the Superannuation is extremely difficult to access until retirement. This is also a potential blessing (forces the saver not to take the ‘easy-option’ and access the savings when a small personal financial crisis comes along.
We have observed this week that a ‘minimum-wage earner’ can produce a 50% better outcome saving via Superannuation rather than in the individual’s name. Imagine what the ‘median-wage earner’ and the ‘high-income earner’, with their much higher marginal tax rates will be able to do… Next week – Tony Hansen 01/08/2014
Update 02/08/14 – A few people have contacted me to inform that the Government ‘co-contribution’ scheme would be a better way for the low income earner to augment Superannuation. It is, but whilst the first $500 in contributions tax are credited back (apparently this is being examined) it is the best to fully exploit both – i.e. ensure you have the full $2,631.60 in pre-tax contributions that would earn the full $500 exemption and then the next $1,000 should be contributed post-tax.
By way of explanation for the Government Co-contribution, imagine the earner described above takes the $1,000 they would have contributed pre-tax and pay their $190 tax. They then contribute the $810 post-tax to Superannuation, and receive $405 in Government Co-Contribution. They have effectively turned the $1,000 into $1,215. This is 21.5% better than the pre-tax outcome & exactly 50% better a starting point than the $810 saved outside of Superannuation. Effectively, this means the $1,000 of pre-tax income foregone could be $10,540 saved outside of Superannuation, $15,900 in Superannuation using the pre-tax sacrifice and over $19,300 with the Co-contribution.
The fact still remains, the low income earner could generate between 50 and 83% better returns inside the Superannuation system than outside.
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|
Apr 1st 2011 |
Jul 1st 2014 |
Current Price |
Current Period |
Since Inception |
|
EGP Fund No. 1 |
1.00000 |
1.56145 |
1.59089*1 |
1.89% |
73.54%*2 |
|
35632.05 |
45991.23 |
47363.57 |
2.98% |
32.92% |
EGP Fund No. 1 Pty Ltd. Up by 1.89%, trailing the benchmark by 1.09% since July 1st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 73.54%, leading the benchmark by 40.62% all-time (April 1st 2011).
*1 after 31May 2013 dividend of 2.333 cents per share plus 1.000 cent per share Franking Credit & 31 May 2014 Dividend of 7.000 cents per share plus 3.000 cent per share Franking Credit
*2 calculated based on dividends reinvested
