The longer road to retirement
THE journey to retirement has just got a lot longer if you're going to depend on the age pension.
Above all, you need to understand how compound interest works. To put it simply, how much you will have at the end of a given period depends on the amount invested, the earning rate, and the length of time of the investment. If the time is short, the rate matters little - the increase in the final benefit grows exponentially.
If you invest $1000 a month at 3% for two years, you will end up with $25,000. Increase the rate of return to 8% and the final balance is just $26,000. Because the term is short, the rate doesn't really matter.
However, if we extend the term to 30 years, $1000 a month at 3% would grow to $600,000, and at 8% $1.5 million. Take the term to 40 years and the numbers become $926,000 and $3.5 million.
Remember, if you're aged 40 now you've almost certainly got at least 50 years of investment ahead of you. Being too cautious, or not getting around to starting, could cost you millions.
No doubt the government's advisers were aware of the mechanics of compounding when they reduced the rate of increase of the age pension. Currently, increases are linked to average weekly earnings, but from 1 September 2017 the rate of increase will be linked to inflation.
Now let's run some numbers based on the assumption that average weekly earnings are running at 4% and inflation at 2.5%, and the couple's full pension now is $30,000 a year.
In 10 years at 4%, the pension would have risen to $45,000 a year - at 2.5% $38,000 a year.
In 20 years at 4%, the pension would be $67,000 a year, but at 2.5% just $49,000 a year.
It is not going to make much difference in the short term but, thanks to the way compounding works, the difference will be huge in the long term.
The government is going to use its knowledge of compounding to slow down the rate of growth in the age pension in an attempt to keep the system sustainable. It's up to all of us to use our knowledge of compounding to start investing at an early an age as possible and get the best return we can achieve on our investments. If we fail to do this, the outlook may be dismal.