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ACST152 INTRODUCTION TO ACTUARIAL

STUDIES

Week 1 Lecture 1C
Calculating Superannuation Balances
The aim is to answer the question;
If I put $C into an account at the end of each year,
and the account earns interest at i p.a, how much
will I have at the end of n years ?
We can do these calculations
1.

Using the formula for the sum of a geometric


progression

2.

Using a spreadsheet

Lets start with method 1

In this lecture we will


(a) Find a shortcut formula for finding the
accumulated value of regular payments of C
per annum at the end of each year
(b) Adjust the contributions for tax and
administration fees
(c) Adjust the interest rate for tax and
administration fees
Next lecture: Allowing for the impact of salary
increases, inflation, and variable interest rates
Before we go any further we need to have a brief
revision of some high school work on Geometric
Progressions

Sum of a sequence of numbers which are in


geometric progression
If numbers are in a geometric progression then each
number in the sequence is equal to the previous
number, multiplied by a constant factorr.
If the first term is denoted a, and the constant ratio is
r, then the sequence is

a,

ar, ar , ar , ar , ar

and so

on ....
Note that the nth term in the sequence is arn-1

Examples:
2, 4, 8, 16, 32..

(a = 2 and r = 2)

-3, 9, -27, 81, -243

(a = -3 and r = -3)

8, 4, 2, 1, , 1/4, 1/8, ..(a = 8 and r = )

Lets suppose that we want to find the sum of the first


n terms in the sequence,
i.e. we want to find Sn where
2

n-1

Sn = a + ar+ ar +ar + .... ar

(eqn 1)

The easiest way to find this sum is to make a second


equation by multiplying throughout by r and then
subtracting the two equations.

r Sn = ar+ ar2 +ar3+ ..... arn


(eqn2)

Subtract eqn 2 from eqn 1.


Most of the terms cancel out.

Sn

= a + ar+ ar2 +ar3+ ..... arn-1

r Sn

ar+ ar2 +ar3+ ..... arn-1 +arn

________________________________
(1-r) Sn = a - arn
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and rearranging gives

a (1 r n )
Sn
1 r
or alternatively you can write

a (r n 1)
Sn
r 1
Either formula will give the same answer.
Example:
(a) Find the sum of the first 8 terms of the
sequence 2, 4, 8, 16, 32...
(b) Find the sum of the first 40 terms of the
sequence 100, 100*1.05, 100*1.052...

Answer (a)
a = 2, r = 2, n = 8

2(28 1)
Sn
2*(256 1) 510
2 1
Answer (b)
a = 100, r = 1.05, n = 40

100(1.0540 1)
S 40
12079.98
1.05 1

Question: What happens if the value of r is 1?


Answer: Sn = n * a
Tutorial Exercise:
Use the method of Proof by Mathematical Induction

a(r n 1)
Sn
r 1
to prove that

Regular Savings
Lets suppose that you are going to save $C every
year. (C = Contribution to Superannuation Fund)
At the end of each year you will put $C into a bank
account, and you will do this for n years.
[Note that when compulsory superannuation was first introduced in 1992, employers were required to make
contributions annually within a few weeks of the end of the financial year. In practice most employers make
contributions monthly. In ACST101 you will learn how to adjust for monthly contributions]

The account earns compound interest at the rate i per


annum.
Q. How much money will you have at the end of n
years ?

We could do this by simply calculating the balance


each year.
Iterative Formula:
If the balance at time t is Bt
Then the balance a year later, at time t+1, will be
Bt+1= Bt * (1+i) + C
Balance of account at time 0 = B0 = 0
(i.e the account has no money at the start of the
first year)
Balance of account at time 1 = B1
B1= B0 * (1+i) + C
= 0*(1+i) + C
=C
i.e. at the end of the year the account holds the
first contribution
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Balance of account at time 2 = B2


B2 = B1 * (1+i) + C
= C * (1+i) + C
Balance of account at time 3 = B3
B3 = B2* (1+i) + C
= [C* (1+i) + C] * (1+i) + C
= C *(1+i)2 + C * (1+i) + C
Balance of account at time 4 = B4
B4= B3 * (1+i) + C
= [C *(1+i)2 + C*(1+i) + C] *(1+i) + C
= C*(1+i)3+ C* (1+i)2 + C* (1+i) + C
And so on.
You can see the pattern emerging.

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The Balance of account at time n = Bn where


Bn = C(1+i)n-1+ C(1+i)n-2+ . C(1+i)2 + C (1+i) + C
And writing the terms in reverse order

Bn = C + C(1+i)+ . C(1+i)n-2 + C (1+i)n-1


This may be written using summation notation
n1

C (1+i)t
t=o

The terms in this equation form a geometric


progression with the
initial term C, constant ratio (1+i), and n terms.
So using the formula previously derived for the sum
of a geometric progression,
Account at end of year n

(1+i)n 1
C
(1+i)1

(1+i) 1
C
i

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Example: Find the accumulated value of $100 paid at


the end of each year for 40 years, if the account earns
interest at 5% per annum.

100(1.0540 1)
1.05 1
=
= 12,079.98

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An Alternative Approach
It is often helpful to think of each separate payment
accumulating in a separate account, for n years.
Find the accumulated value of each payment at time n years, and
then add them together.
The first payment of $C is made at time t = 1 and
earns interest for n-1 years
Accumulated value of first payment = C (1+i)

n-1

The second payment of $C is made at time t = 2


and earns interest for n-2 years
Accumulated value of second payment = C
(1+i) n-2
The third payment of $C is made at time t = 3 and
earns interest for n-3 years
Accumulated value of third payment = C (1+i)

n-

And so on.
The last-but-one payment is made at time t = n-1
and earns interest for one year
Accumulated value of last-but-one payment = C
(1+i) 1
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The last payment is made at time t = n and earns


no interest
Accumulated value of last-but-one payment = C
(1+i) 1
If all these separate accumulated payments are
added together, we get

Bn = C(1+i)n-1+ C(1+i)n-2 + . C(1+i)2 + C (1+i) + C


And writing the terms in reverse order

Bn = C + C(1+i)+ . C(1+i)n-2 + C (1+i)n-1

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So this is just another method of getting to the


same resultACTUARIAL NOTATION FOR
ACCUMULATED VALUES
Since this type of calculation is very common in
actuarial work, the actuaries got together about 100
years ago and decided to all use the same notation.

sn

is the symbol for the accumulated value of


payments of $1 per year, made at the end of each year
for n years, at rate of interest i per annum compound.
in arrears means at the end of the year
in advance means at the start of the year

sn

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[(1 i ) n 1]
i

Examples:
Find the values of the following
(a) $50 per annum payable in arrears for 20 years at
the rate of interest 10% per annum
(b) $200 per annum payable in arrears for 60 years at
1% per annum
Answer (a)
50s20

(1.1020 1)
at 10% 50*
0.10
2863.75

Answer (b)
200 s60

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(1.0160 1)
at 1% 200*
0.01
16,333.93

REASONABLENESS CHECKS
Everyone makes mistakes from time to time.
Therefore, whenever you do a calculation, it is
important to look at the answer and say:
Does this answer look reasonable ?
Or is it obviously wrong?
If you were earning NO interest, then the accumulated
value would be just the sum of n payments of $R,
i.e. n * R.
If you are earning a positive rate of interest, then the
accumulation should be HIGHER than n*R.
So whenever you do an accumulation calculation,
accumulating n payments of R each, check to make
sure that your answer is higher than n * R.
Example: $200 for 60 years at 0%
would be 200*60 = 12,000
Our answer of 16,333.93 was larger - OK
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SUPERANNUATION ACCUMULATIONS
Theoretically, we could use the above formulae to
estimate the accumulated value of our superannuation
savings at retirement age (say age 65).
Lets suppose that your employer is complying with
Australian law and paying 9% of your salary into a
superannuation fund earning 8% per annum interest.
Your salary is $50,000 per annum, so this means that
the contribution is $4500.
Assume payments are made at the end of each year.
Using the formula for the accumulated value of
regular payments, after 40 years you will have
4,500

s40

at 8% = 1,165,754.33

You will be a millionaire !


Sadly, this is much too optimistic...

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COMPLICATIONS
Unfortunately real life is more complicated !!!
We must allow for :
1.

Taxes on contributions

2.

Administration Fees & Insurance costs

3.

Taxes on investment income

4.

Investment management fees (asset based


fees)

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5.

Salary increases

6.

Inflation of the cost of living

1. TAX ON CONTRIBUTIONS
The first problem is tax on contributions.
The government charges a tax of 15% on each
contribution made by the employer into a super fund.
(NB In reality there are different tax rules for different
types of contribution, but we will ignore this at
present this is a simplified model)
Tax = 15% * 4500 = 675
Net Contribution after deducting tax
= 4,500 - 675 = 3,825
Accumulated value of net contributions
= 3825

s40

at 8%

= $ 990,891.18
So you wont be a millionaire, but it still looks okay.
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2. ADMINISTRATION FEES & INSURANCE


However, the superannuation fund will also charge
you an annual administration fee.
Different funds charge different fees, but it is likely
that the fee will be at least $50 per annum. (This is
probably on the low side).
Note that some funds charge
a flat fee say $X each year
but others charge a percentage of the amount you
contribute
say 1% of 4500 = $45,
and some charge both a flat fee AND a percentage
fee.
[NB The total amount of fees paid by Australian
superannuation fund members in one year is about
$13 BILLION. Some people think that the
superannuation funds are over-charging; we will look
at this issue later in the term.]
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Also, most superannuation funds buy life insurance


policies for all their members.
so if you die, your orphaned children will have
enough money to survive and prosper.
Some also buy disability insurance for their
members
so that you receive a payout if you are injured or
become ill and unable to work.
The cost of the insurance is deducted from your
account each year.
The cost will vary from fund to fund, since some
funds provide a high amount of insurance and others
provide a much lower amount. Lets say that you pay
$150 per annum for insurance. (This is probably on
the low side)

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So the net contribution, after taxes, insurance, and


admin fees, is
Gross contribution
Less tax

4500
675

Less admin fee

50

Less insurance

150

Net Contribution

3,625

So your accumulation is down to


3625

s40

at 8% = 939,079.88

Note that allowing for contribution taxes,


administration fees and insurance has reduced your
savings by about 20%.
[Down from $1,165,754.33 to 939,079.88]

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3. TAX ON INVESTMENT INCOME


Sadly there is more bad news !
Investment income is also affected by taxes and
fees.
Investment income is taxed at 15%.
[In practice, due to various special deductions and
concessions and special treatment of capital gains, the
actual tax paid is usually less than 15%. The details
are too complicated for first year students.]
If the gross interest rate is i

And the government takes tax of t*i


Then the net interest rate is i *(1-t)

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Example: Suppose that a person has $100 in their


account at the start of the year
Interest

= 8.00

Tax on interest = 15% * 8

= 1.20

Net interest after tax = 8.00 1.20 = 6.80


So the net interest rate after tax is
= 8% * (1-0.15) = 6.8%
Our accumulated value is now down to
3625

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s40

at 6.8% = $ 687,402.88

4. INVESTMENT MANAGEMENT FEES


Of course superannuation funds also charge you an
investment management fee.
This money is used to pay the investment managers
who provide their expert skills in managing your
investments, and also covers investment-related
transaction costs such as brokerage.
This fee is an asset-based fee, i.e. it is usually a
percentage of the balance of your account.
The percentage usually varies according to the type
of the investment if you invest in something
simple like government bonds then the rate might be
just 1%, but if you invest in something which
requires a lot of research and expertise, like private
equity or hedge funds, it might be 2% or more.

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Lets be optimistic and assume that you will only pay


1% per annum, and the fee is applied by reducing the
net interest rate credited to your account. (In practice
there are different methods of calculation but this is a
simple approximation).
To work out the net-of-tax-and-fees interest rate,
lets assume that
Gross interest rate = 8%
Net of tax interest rate = 6.8%
And if investment management fees are 1%
Net of tax and fees interest rate = 5.8%
Our accumulated value is now down to
3625

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s40

at 5.8% = $ 533, 582

OVERALL IMPACT OF FEES AND TAXES

Note that fees and taxes make an enormous


difference to the outcome.
In this example, the final balance after allowing
for fees and taxes and insurance costs is only
about 46% of initial amount.
A small difference in the fees makes a big
difference to the outcome.
Q. How much would the accumulation be, if the
fund charged an investment management fee of
1.5% , instead of 1% per annum?
Answer = $471,321
Increasing the investment fee by half a percent
reduced the payout by more than $60,000
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ADJUSTMENTS TO FINAL PAYMENT


Some funds also charge an exit fee, which is
theoretically designed to cover the cost of processing
the paperwork for payments. It is usually a relatively
small amount.
In the past, the government would also charge a
benefits tax at the end, when you took your benefit
out of the fund.
Fortunately, a few years ago the government decided
to change the rules so that you dont have to pay tax if
you are over age 60 when you take the benefit out of
the fund.
If you take out money before age 60, i.e. retire
early, then you WILL have to pay tax.
Q. Why is there higher tax if you take money out
before age 60?

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Next week:
Allowing for salary increases
Allowing for inflation
Allowing for variations in the investment income
earned by the fund each year
Superannuation Calculator
Over the next two weeks you will be building your
own superannuation calculator.
Tute exercise: Look at ASICs superannuation
calculator
Homework: Start learning EXCEL skills.
Watch the EXCEL demo on iLearn in the week 1
folder and build your own version of the spreadsheet.

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