What should a super fund return?

It’s a good time to be one of the 12 million Australians with a superannuation fund.

Surging sharemarkets have bolstered returns over the past three years, wiping out the majority of losses accrued during the global financial crisis.

The median balanced super fund posted a 9.7 per cent return in 2013-14, marking the sixth consecutive year of positive returns, according to research house SuperRatings.

It has brought the median balanced fund’s returns over the decade to a respectable 6.5 per cent a year.

But those investment returns don’t tell the full story.

During the past decade, the typical investor saving for retirement has experienced a high of 15.7 per cent in 2007-08 and a low of -12.7 per cent in 2008-09.

It’s boom or bust for an investor aiming for 6.5 per cent – or one chasing even higher returns.

That’s because most super funds don’t aim to deliver an absolute return every year: they aim to outperform the rate of inflation by three to four per cent a year over the long term.

Outcome-based investing

But the 'inflation plus' approach is cold comfort for investors who increasingly want their investments to meet specific goals and outcomes if they are to have any hope of enjoying a comfortable retirement.

While strong recent returns have bolstered the median balanced super fund, the future looks less certain.

Official interest rates are at historic lows and, with annual inflation running at just two to three per cent, super funds are being forced to invest in more volatile assets to continue generating the type of returns investors demand.

Sadly, the investment risk each fund takes is ignored in super performance tables despite the catastrophic losses endured by older Australians through the GFC.

Any comparison of one fund against another can’t be based on returns alone.

The industry has tried to make it easier for an investor to assess the riskiness of their super by launching a simplified standard risk measure, which estimates the number of negative years out of 20 that a default MySuper fund is expected to rack up.

Most funds estimate this at about four years across two decades. However, it is a deeply flawed system.

For one thing, it encourages the ‘gambler's fallacy’, where an investor believes that oncoming events are less likely to occur because of past events.

For example, an investor in a super fund which has posted two recent years of negative returns may think the future looks brighter because the fund has estimated four years of negative returns in every 20 years.

Unfortunately, past events do not change the probability of similar events occurring in the future: each year has the same 20 per cent chance of posting a negative return.

While the MySuper standard risk measure attempts to give an indication of the frequency of negative returns, it also completely ignores the magnitude.

Investors feel a sharp difference between losing 19.7 per cent and 1.9 per cent, which the median super fund did in calendar 2008 and 2011 respectively.

Taking volatility into account

A better way to measure risk is to rank volatility against returns. It gives an indication of the risk the fund is taking per unit of return generated and would allow a better comparison between funds.

The financial services industry is expected to start developing new risk-return measures with almost half of super fund executives also expecting a swing towards absolute-return objectives over the next decade, according to a recent Australian Institute of Superannuation Trustees (AIST) and BNP Paribas Securities Services research project.

They are crucial considerations with the ride to retirement expected to be a volatile one. More than two-thirds of super fund executives say they expect another major market downturn to strike over the next decade, according to the same AIST/BNP Paribas survey.

Managing this downside risk is particularly important for retirees who risk locking in losses once they start spending their savings.

However, with the average Australian now expected to spend decades in retirement, older investors still need to maintain a healthy exposure to higher-returning (but volatile) assets such as shares.

It’s a classic Catch-22.

In response, super funds are likely to launch a range of increasingly sophisticated solutions to manage volatility and shift the risk-reward equation back in favour of investors.

Weighing up super fund risks, as well as returns, should remain a key concern for those planning to be one of the 12 million Australians with the means to enjoy a fruitful retirement.

This article was first published in Investor Daily.