Superannuation is unlike any other product. Most of us are forced to spend almost 10% of our working incomes to buy it and yet have no guarantee about what we will actually receive.
Throw in low levels of financial literacy and high levels of disengagement and it can easily become a genuine gamble.
The ultimate outcome is based on the level of contributions, fees and investment returns–but only the first two are relatively predictable.
Investment returns and risk are largely left to the individual, who is told to focus on the long-term, which is generally solid advice for young investors who can ride out the ups and downs of markets over decades.
But it can also cause disengagement. Unfortunately, this is something many super funds are exacerbating by cutting investment return targets and raising their risk outlook.
Why investors are facing a future with lower returns and more risk
Super funds can’t offer investment return certainty but they can offer long-term probabilities. Default funds typically express this through a real return target, typically around CPI plus 3.5%.
While the median super fund has outperformed this target in recent years, many have lowered their expectations, including Telstra Super, Cbus, SuperSA, QSuper, Military Super, Christian Super and Kinetic Super. Even the Future Fund, which has more than doubled the government’s original $60.5 billion allocation in just over a decade since its inception, is now lobbying to lower its target of CPI plus 4.5 to 5.5%.
The reason? The risk-free rate of return has fallen to historic lows in recent years.
Bonds may be considered a defensive asset but they have posted growth-like returns as inflation has fallen dramatically. Australian bonds posted gross annualised returns of 8.7% a year and (hedged) global bonds 9.2% a year over the 30-year period ended January 31, 2017, according to Morningstar.
But the bond bull market may now finally be ending as central banks around the world slowly rein in their loose monetary policy and inflation expectations pick up.
Lower returns from bonds will act as a significant drag on the majority of default portfolios, which are split 70:30 or 60:40 between growth (predominately equity) and defensive (predominately bond) assets.
Funds are faced with a choice: increase risk to maintain returns or lower return targets. In October 2015, the Reserve Bank of Australia raised concerns that life insurance firms and defined benefit super funds had begun investing in riskier assets to compensate for low yields. And as we have seen, many defined contribution super funds have already cut their return targets.
The rise of peer risk and herd behaviour
In any other industry, such a significant change in market conditions would prompt structural change and drive many entrenched players out of business. Only successful innovators would survive and prosper.
But that isn’t the typical scenario in an industry where the superannuation guarantee compels billions of dollars in annual inflows and engagement levels are low. It encourages herding behaviour rather than innovation–and the industry knows it.
Several super fund executives who took part in a 2014 Centre for International Finance and Regulation survey expressed concern about herding behaviour among funds seeking to avoid being ranked in the lower tiers of performance tables.
Such concern centred on “peer risk” can drive similar default asset allocations (or strategies) even for funds with materially different member characteristics such as average age and balance (something the Productivity Commission is currently investigating).
What options then do funds have given that many are already diversified across a wider range of assets such as infrastructure, direct property and alternative assets?
Innovation, engagement and meeting member needs
Understanding the differing needs of members is crucial. Unfortunately, few members can say their super fund has ever asked them what they actually want. Finding answers across a mass membership is not easy but, with major cloud-based analytical firepower now widely available, it is a more obtainable goal than ever before.
As funds learn more about their members, they can pursue more innovative strategies to match risk and return to suit different groups.
Older members and those with larger balances, who are more sensitive to risk (both volatility and maximum drawdown), need special attention.
Rather than automatically reduce investment return targets or increase investment risk, some funds are exploring alternative options beyond 70:30 style default funds. No single approach is perfect, but whatever strategies are chosen, they should ultimately increase the probability that members meet real (not assumed) goals.
The Future Fund may be a unique example (no members and no inflows), but it has taken a far more absolute return approach than typical super funds–even with the knowledge that government could start drawing down funds from 2020. Similarly, some super funds are taking a greater risk parity approach (that goes deeper than simply gearing up bonds) by focusing on the amount of risk in each portfolio allocation rather than the specific dollar amounts invested.
Maritime Super has also recognised the role of risk–last year, it applied a futures-based risk overlay (managed by Milliman) aimed at controlling extreme volatility and limiting capital losses to its default MySuper option. Its membership is older and has higher value balances than many other industry funds.
Other funds are now using futures to tilt their portfolio allocations based on relative valuations over the short term. This type of implementation management can potentially better manage risk and marginally improve returns.
These are just some of the innovations currently taking place as funds differentiate themselves and leave herding behaviour behind.
Superannuation may be unlike any other product, but Australians deserve better odds that it will meet their actual needs.
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