This is gonna suck, first off. Just so you know.
The number that gets tossed around a lot, internationally, is the S&P500 returning 10% nominal or 7% real average return. This number is correct, on its face.
However, tax has to be accounted for. In the US, tax is paid when the fund is sold, at your marginal tax rate for that year. That means go ahead and use 7% on your calculations, but your final retirement figure should be gross income as it’s taxed in that year.
In NZ, for investment funds that hold overseas assets, taxes are taken out every year at your marginal tax rate for that year as long as you have more than a certain amount. Yes, really. (We’ll disregard NZ-based assets for now, since the S&P500 isn’t NZ-based; a home bias is reasonable, keeping your entire portfolio at home is a bit silly.) That’s 33% for most of us – refer elsewhere for why FIFs are better than PIEs – because of course these are your earning and saving years. Horribly tax inefficient, it is.
This has a devastating effect on compound interest, and thus on required savings. As follows.
- FIF, declared actual change in value. Using the same assumption as before of 3% inflation, 10% nominal return becomes 6.7% nominal after taxes, or 3.7% real.
- PIE, 7.2% nominal after taxes, 4.2% real.
- FIF, claimed 5% increase. That’s 1.7% taken in taxes, so your 10% nominal return becomes 8.3% nominal, or 5.3% real. This is literally the best case scenario. It works out a little better given FIF rules, but not enough better to justify using no-tax assumptions.
Astute readers might notice that the tax paid on that last is 1.7% regardless of actual return. Yep. FIF rules, man. Even so, the difference between 5.3% and 7% is…really, really significant.
(insert graph here)
Now let’s see what a bond fund might return. Before taxes it might be 6% nominal, 3% real.
- FIF, declared actual change in value. 6% nominal becomes 4% nominal after taxes, 1% real. Not even kidding.
- PIE has 4.32% nominal return after taxes, 1.32% real.
- FIF, claimed 5% increase, took a 1.7% haircut. 4.3% nominal return, 1.3% real.
1.3% is well within the ballpark of what an active fund manager charges. Hell, it’s not that far off what I charge. That’s scary. Between me and the fund fees (which to be fair are taken off pre-tax, but even so), there’ll be no growth left for you.
Basically, at higher returns you start to approach the rest of the world’s returns. At lower returns, you’re lucky to keep your purchasing power after inflation. There are actually really good reasons why local investors like property so much, and this is one of them. Just saying.
The good news is, there will be no tax to pay on withdrawal. This means you can reduce your FI# by calculating it off expected retirement expenses, rather than pre-tax required retirement income. It’s…not exactly a wash. But it’s something.