Re-rating the risk factor

The mist of confusion over labels such as conservative, balanced, growth and defensive was cleared a little last week when a standardised risk description started to appear alongside superannuation fund investment options.

The move is timed to coincide with the deadline for all product disclosure statements to be made available in short form - eight pages, tops. The ranking will form part of the PDS.

Developed by the Financial Services Council (FSC) and the Association of Superannuation Funds of Australia (ASFA), with the support of industry regulators, the "standard risk measure", as it's formally known, will have seven bands that range from very low to very high.

The ranking will be assigned according to how many negative annual returns the investment option can be expected to have during a 20-year period - in other words, how often you stand to lose money.

An investment option estimated to have less than one negative annual return every 20 years will be ranked low risk, for example, while a fund that tends to have six or more negative years in 20 will be ranked very high risk.

Importantly, the new industry rules also stipulate that the label "conservative" should be used only when the estimated number of negative years is less than two in 20 - in other words, it can only be applied to investment options that have a standard risk measure of very low, low or low-medium.

"That label, 'conservative', will now have to mean very conservative by anybody's standards," the FSC's director of policy, Martin Codina, says.

The standard risk measure grew out of discussions over the fact that terms such as balanced could mean one thing in one fund and something different in another. One fund's balanced option might be a 60-40 split of growth and defensive assets, while for another it was 45-55.

Fund trustees will have some discretion in the way they calculate the risk measure, Codina says.

"But wherever there is room for discretion, that discretion has to be exercised in favour of the consumer," he says, so the risk is overstated rather than understated.

There has been criticism in some quarters that the standard risk measure is an oversimplification of the multilayered concept that is risk, and that fund members might perhaps wrongly avoid options with risk labels in the upper bands.

The director of investment services for Towers Watson in Australia, Graeme Miller, says the measure is a step in the right direction but he hopes it will evolve over time.

"Having more standardisation in the way different funds articulate and measure risk is positive," Miller says.

"In our view, though, [the tool] is rather simplistic.

"One of the dangers it has is that it doesn't recognise that risk is multidimensional and the likelihood of a negative return is only one of the many different risks the investor faces."

The standard risk measure doesn't tell the story of the severity of the negative returns involved, for instance.

"There's a big difference between being slightly negative and getting minus 20 [per cent] or minus 30 per cent," Miller says.

It doesn't capture the fact that while two options might have a three-in-20 chance of a negative return, returns for one range from minus 5 per cent to plus 15 per cent, while the other swings from minus 7 per cent to plus 25 per cent.

Nor does it address the likelihood of a particular investment option achieving the ultimate financial goal. "It doesn't tell me much about whether [the contributions and returns] are going to be sufficient to provide retirement security," Miller says.

Codina says there are limitations, but the industry had to start somewhere. "We think it's actually going to be quite powerful," he says, noting that the Australian Securities and Investments Commission can prosecute if the investment labels are misleading.

"If you have an investment option that you'd like to call balanced but you put it through the risk measure and it comes out very high risk, ASIC will be coming to you and saying, 'How do you reconcile the fact that you call this balanced but the risk measure is very high?'," Codina says.

"In an indirect way, that's going to force the industry to have a good look at existing labels and whether they're appropriate."

And it could even prompt some "reverse engineering". It's understood that one leading provider felt compelled to restructure a new product ahead of release after running it through the standard risk measure process and finding it came out high risk.

The provider revised the investments so the product could achieve the medium-risk label it desired.

ASFA's general manager for policy and industry practice, Margaret Stewart, says the labelling needs to be taken further "so people can further understand the relationship between risk and return - that risk is not necessarily a bad thing, that different investments have different risks over certain periods within a person's life".

It could be high risk, for example, for a young person to have their money in cash over 20 to 30 years, she says, because of the impact of inflation and cash's generally lower returns.

"The first reaction when people see a high number of negative returns could be that they automatically think that's a bad investment, it's a really risky investment," Stewart says.

"But that needs to be overlaid with what their needs are at the time. We need to get the message out that you shouldn't look at risk in isolation."

Key points

O Super fund investment optionswill now carry a standard risk rating.

O The rating will be based on theexpected number of negative yearsin two decades.

O The label conservative will berestricted to options in the bottomthree bands.

O One concern is that there will bea knee-jerk reaction to a highrisk rating