Manufacturing inflation risk protection
Examining various wealth management solutions, both existing and new, that provide inflation-protected benefits designed to meet consumers' wealth accumulation and post-retirement income needs.
The role of risk in superannuation looks set to be all but completely subsumed by a long-term perspective, according to a Productivity Commission draft report.
This is a dangerous approach which fails to acknowledge the underlying goals of an ageing population and shows that the industry has learnt little from the impact of the global financial crisis.
The Commission’s draft report, “How to assess the superannuation system's performance,” suggests that system-wide average net returns reflect the impact of diversification and average market volatility. It is in line with the industry’s view that a long-term measure of 20 years effectively captures risk-adjusted returns.
Unfortunately, it doesn’t reflect the reality of investors–this is what needs to guide the decisions of funds.
Australia’s population is ageing rapidly. A rising proportion of super members have shorter investment timeframes, meaning volatility and capital losses play a far greater role in their retirement outcomes.
This affects a significant number of investors. Members aged 45-64 years account for 58.1% of all super assets, according to the Association of Superannuation Funds of Australia (ASFA). However, many of these members will retire well before the age of 65.
A 2014-15 survey by the Australian Bureau of Statistics (ABS) found that 8% of 45-49 year olds had already retired while 18% of 55-59 year olds had retired (although ABS noted that this may be lower than actual rates). The average age for those who had retired in the last five years was 61.5 years.
It was not a choice for many of those retiring early. The most common reasons, aside from reaching retirement age, were sickness, injury or disability, or being retrenched and unable to find work.
This ageing population, which also has significantly higher super balances, will not necessarily have the benefit of time to manage their rising risks.
Ignoring risk by taking a long-term perspective fails to take into account the behaviour of members, which is often driven by emotion-charged cognitive failures.
The global financial crisis, which dragged down nearly all major asset classes in 2008-09, stands as a prime example. Approximately 5% to 7% of fund members shifted to lower risk investment strategies after the market peaked in November 2007, according to a study by the Centre for Retirement Incomes and Financial Education Research (prepared for the Australian Institute of Superannuation Trustees in late 2009).
While this appears to a good result, unfortunately those members who shifted were older, had larger balances and had contributed more to their super. They had the most to lose–and likely lost the most by switching at the worst time.
The report found a surge of surge of switching beginning in October 2008 and ending in March 2009, just as the market reached its low point. The market then surged more than 44%, but the report’s authors found investors still remained in their low-risk investment options by September 2009.
Older investors are even more prone to “loss aversion” than younger investors–they feel the pain of losses more acutely than the pleasure of gains.
The study’s findings underlined that tendency: it found that older age groups were more active following negative share market return periods whereas younger age groups were more active following positive market return periods. Loss aversion is just one of many behavioural finance tendencies where investors work against their own best interests.
A 20-year long-term perspective may effectively capture risk-adjusted returns but it doesn’t reflect the damaging risk of investor behaviour, which all too often destroys real returns.
All investors want strong returns, but it is more often unseen risk that derails their retirement plans.
Measuring returns is relatively simple. Measuring risk is where the challenge lies. The industry has many technical measures of risk such as Jensen’s Alpha, Value at Risk, Sharpe ratio, Treynor Ratio and Sortino Ratio.
But these are far beyond the grasp of most members. Even the Australian Prudential Regulation Authority’s standard risk measure, which attempts to estimate the number of negative annual returns over any 20-year period, can mislead investors thanks to its inherent cognitive biases.
Ultimately, risk must be linked to a member’s goals.
This requires funds to use far greater actuarial and technical firepower to analyse the disparate needs of their members. It also requires funds to make far fewer assumptions about what their members require.
For example, the industry regularly relies on “comfortable retirement” measures even though these measures often neglect money and assets outside of super (which account for the bulk of household savings).
The only way to find out this information is to forge a far closer relationship with members. This will, in turn, underpin more tailored communications, investment strategies and product solutions.
This is a harder path for funds but one that will differentiate them from other funds and create closer ties with members.