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?
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.
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.