What is superannuation and how does it work?

We're all undoubtedly familiar with our employer's contributions towards our superannuation — or 'super' — each pay cheque. But what exactly is super, how does it work, and why is it so crucial for a long and happy retirement?

What is superannuation?

Superannuation is money set aside by your employer throughout your working life to help support you financially throughout your retirement.

The money is invested in a super fund, basically just a big portfolio of shares and other investments overseen by a fund manager. The goal of the fund manager is simply to grow the value of your savings over time.

Because super is designed to provide you with an income stream in retirement, you typically aren't permitted to withdraw from the fund unless you are over 65 and no longer employed.

How does it work?

Your employer is legally obligated to contribute a minimum percentage of your earnings into a super fund each time you get paid. Called the 'super guarantee', the contribution amount is currently set at 10.5% of your ordinary time earnings (ordinary time typically excludes overtime). 

This amount is paid directly into your super fund by your employer — and is on top of your regular earnings. The guarantee was increased from 10% in July 2022. It will continue to increase by 0.5% every year until it reaches 12% in July 2025.

Typically, you can nominate your preferred super fund. However, if you don't have an existing super fund — or neglect to appoint a preferred fund — your employer will always have a default fund into which they can pay your contributions. 

Try consolidating your super as much as possible and avoid opening accounts with multiple funds. Management fees and other costs can quickly erode your returns.

Super has two broad phases — the accumulation phase and the retirement phase. The accumulation phase corresponds with your working life. It is the period during which your employer contributes to your super, and you are growing your wealth for retirement. Unless you meet certain criteria, you are typically prevented from withdrawing any of your super during this phase.

Once you retire, your super is transferred to a pension to support you in retirement. Depending on how much you have, your super will be used to supplement or entirely replace the age pension.

How does compound interest work?

Super is an effective way of saving for retirement because it harnesses the power of compound interest. 

Before your retirement, any earnings from your super — like dividends and interest payments — are taxed at just 15% and then reinvested into your super account. This effectively means that you earn interest on your interest — which is referred to as compound interest.

The only absolutely necessary ingredient for compounding is time. The longer you leave your money alone and untouched, the greater the potential benefit from compounding.

Here's an example

Take the simple example of a $100,000 term deposit earning 5% interest a year, which is paid annually. 

You have two options: You can have the interest distributed as a cash payment each year or have it reinvested into your account. The second option will see the interest payments added to your existing capital, and you will earn the 5% annual interest.

After 10 years, if you had selected the first option, you would have received $50,000 (5% of your $100,000 each year for the 10 years). However, if you had taken the second option and left your money alone to compound over time, you would now have $162,890 in your account — almost $13,000 more just for leaving your money alone!

Of course, with super, you are not just making an initial one-off contribution when you open your account. Instead, your employer makes regular contributions each time you're paid, with each of these payments remaining to compound over time. 

This means the more money you can put into your super while you're working — and the longer the timeframe you leave it there to compound — the more you'll have in retirement.

A short history of superannuation in Australia

Superannuation did exist before the 1990s in Australia but was mostly confined to public servants and white-collar employees of large corporations. 

However, with Australia's ageing population, it became apparent that the number of people in retirement would soon strain the nation's existing age pension. The solution was to expand superannuation to cover more of the country's population.

In 1992, the Keating government introduced the super guarantee, mandating that all employers contribute money into a super fund for all their employees. 

Compulsory superannuation formed part of Australia's three-pillar system for funding retirement, alongside voluntary savings and the aged pension. In 1992, the super guarantee was set at just 3% of an employee's earnings, but it has gradually climbed to more than 10% over the years.

Superannuation rules were changed in 2005, allowing employees to nominate their super fund rather than having their contributions paid into their employer's default fund. 

This kicked off a period of consolidation within the super industry — between 2004 and 2019, the number of super fund entities reduced from 1,511 to just 207.

From around $150 billion in 1992, superannuation assets had grown to a whopping $2.9 trillion by 2019, with nearly 80% of the population holding a super balance.

What are the different types of super funds?

There are two main types of super funds: accumulation funds and defined benefit funds.

Accumulation funds: Most super funds are accumulation funds. In this type of fund, the contributions made by your employer — as well as any additional voluntary contributions you have made to your super — simply accumulate over time. 

The amount of money you eventually receive in retirement depends on the total value of the contributions plus the investment returns earned by the fund (less fees and costs).

Defined benefit funds: In a defined benefit fund, the amount of money you receive in retirement is based on a formula rather than the return earned by investing your super contributions. Defined benefit funds are mostly being phased out, with few still open to new members. However, their payouts can often be quite generous.

Generally, the amount of money you receive in retirement from a defined benefit fund is calculated based on three criteria. Your average annual salary in the years before retirement, the length of time you have worked for your employer, and the amount of money you and your employer have set aside in your super fund.

One of the key differences between an accumulation fund and a defined benefit fund is who bears the risk. In an accumulation fund, you, as the employee, take on the market risk — if the financial markets plummet as you're hitting retirement, that can significantly decrease the amount you'll receive in super.

However, the amount of super you'll receive in a defined benefit fund doesn't depend on the financial markets. Instead, it is based on your salary and the length of time you worked with the company. Therefore, it's up to your employer to come up with the money for your super, regardless of market conditions.

What are the main categories of super funds?

Super funds all fall under one of the below categories:

Retail funds: These are for-profit funds run by financial services companies and are usually accumulation funds. They are open to members of the public and will try to appeal to new clients by outperforming their competitors. While retail funds often offer a wide range of investment options, they may also charge higher fees.

Industry funds: Originally set up for workers in particular industries, such as construction or healthcare, these funds are now open for anyone to join. They may not offer as wide a range of investment options as retail funds, but industry funds are typically lower-cost and not-for-profit. Like retail funds, they are also typically accumulation funds.

Public sector funds: Public sector funds are not-for-profit like industry funds and usually charge low fees. Initially created for state and federal government employees, some public sector funds have now opened to the general public. Most members of the fund will have accumulation products. However, some older members may still have defined benefit accounts.   

Corporate funds: If a business is large enough, it may operate its own corporate fund. It is only available to those currently working at the company and is the default fund offered to new employees. As with public sector funds, some older members may still have defined benefit products, but most will be in accumulation funds.

MySuper: MySuper isn't really a category of fund but a product. To be eligible to receive contributions for new employees, every super fund is required by law to offer a MySuper account as its default product. The government's MySuper initiative aimed to provide all Australians with a basic, low-cost investment option.

Where do self-managed super funds come in?

Investors who want complete control over their investments can set up a self-managed super fund (SMSF). If you open your SMSF, you act as the fund manager and decide how your super contributions are invested.

If you'd like to include any other friends or family in your endeavour, your SMSF can have up to six members, each of whom must be a trustee of the fund.

SMSFs allow investors to oversee all the investment decisions made by the fund — but they are also tightly regulated by the Australian Taxation Office (ATO), which can make compliance and administrative costs relatively high. 

Always seek professional advice before setting up an SMSF so that you are aware of the responsibilities, costs and risks involved. 

Benefits of superannuation

Super has plenty of benefits — far too many to document in detail here. But chief among them is that it helps you remain financially self-sufficient in retirement. 

This means you can enjoy the years when you aren't working — and you can rest easy knowing you have the savings available to cover any unexpected medical bills or other cost of living expenses that might pop up in old age.

Your money is also managed by a financial professional. Depending on your view of the financial industry, that may be a benefit or a disadvantage. But it at least saves you the hassle of having to do your research into shares and other asset classes. 

And because your money is pooled together in a fund with other investors, you can potentially invest in assets you might not otherwise be able to afford if you were building a portfolio on your own.

Super also provides tax advantages. Super contributions paid by your employer are usually only taxed at 15%. This can give a significant advantage if you are in a higher tax bracket. 

This includes any additional salary sacrifice contributions you make from your pre-tax income. After-tax personal contributions are usually not taxed at all (up to certain limits).

As mentioned earlier, earnings on investments in the fund are only taxed at 15%. If you access your super after age 60, withdrawals from your super fund are also generally tax-free.

And the disadvantages?

The obvious disadvantage to super is that you are usually prevented from accessing it until you retire. There are exceptions to this rule, such as if you encounter financial hardship or receive a terminal medical diagnosis. However, in most cases, this will mean you can't get your hands on your super until you reach retirement age.

High fees can also be an issue, depending on your invested fund. If you change jobs frequently and work for many different employers, you may inadvertently open several super accounts, each with only small balances. If this happens, there is an increased risk that you might find your returns severely eroded by fund fees.

How to choose a super fund that's right for you

There are many different super funds available. Before choosing the right one, make sure you understand all the fees and other costs involved. Also research the fund's historical returns to ensure it has a track record of success. 

Depending on the fund, it may offer many different investment options catering to varying levels of risk, so choose a fund that provides the right product for your risk appetite.

Finally, some funds offer ethical investment products. This might appeal to you if you want to positively contribute to society by investing in environmentally sustainable companies.

Which is better: Topping up your super or buying more shares?

Whether you should top up your super or add more shares to your portfolio comes down to your personal preference, investing experience, and risk tolerance.

Super is a long-term, generally lower-risk investment. Because super is a pooled investment with many other individual investors, it gives instant diversification benefits. 

However, unless you run your own SMSF, you generally don't get much oversight or control over where your money is invested. And although there are many tax advantages to super, you also have to contend with management fees and other costs.

Topping up your shares gives you complete control over your investments — plus, it means you can access your money whenever you want. However, when you're buying shares on your own, you can't diversify your investments the same way as a large super fund.

Also, if you do not have much financial expertise, buying shares can be a much riskier proposition than topping up your super fund, which is managed by a financial professional.