Risk and returns a rocky road

The last big peak in the Australian sharemarket was November 2007 - five years ago. Late that month, a bear market started that lasted until March 2009 and it was during that period that investors bore the full brunt of the market dislocation brought on by the global financial crisis.

Our super funds have only now regained the ground they lost. Superannuation research company SuperRatings says strong September quarter returns of 4.3 per cent for balanced funds have pushed the funds through the GFC barrier.

The chairman of SuperRatings, Jeff Bresnahan, says: "While funds are still operating in a challenging environment, sustained momentum will allow members to re-engage with the benefits that superannuation will provide in retirement."

According to SuperRatings, the average return of balanced options was 9.9 per cent in the 12 months to the end of September. In the past three years, balanced options have produced an average return of 4.7 per cent a year.

The average return of growth options was 11.3 per cent in the 12 months to September and 4.4 per cent a year in the past three years.

The average return of capital stable options was 8.4 per cent in the 12 months to September and 5.5 per cent a year in the past three years.

Welcome as these returns are, it would be a mistake to think you can sit back and let the super take care of itself for a while.

In the past few months, the debate has intensified over what investors should do to manage the impact of investment risk and longevity risk on their funds.

There is even a new risk to contend with - sequence risk. In a speech last month, former Treasury secretary Ken Henry argued that retirement outcomes were not only affected by the variability of market returns but also by the sequence in which those returns occurred.

Henry says: "Equities are viewed as growth assets, as assets that provide fund members with upside exposure beyond what is offered by a fixed-income product and it is argued that the benefit of fund members being exposed to such growth assets is increasing as people live longer and as they become more aware of longevity risk. Frankly, I find these arguments absurd."

Henry provides the following example. Suppose it is known with absolute certainty that a share portfolio yields a 10 per cent rate of return in 19 out of 20 years and a negative rate of return of 50 per cent in the other year. But nobody knows in which of the 20 years the negative return will occur.

Superannuation fund members invest an amount every year for a number of years. If the market crash occurs in year one, the overall impact will not be great because not much has been invested average annual yield on the member's portfolio over the full 20 years will be 9.5 per cent. Only one-20th of the total capital invested is affected by the crash.

But if the market crash occurs in the 20th year, then all 20 annual contributions are affected and the annual average return would be just 3.3 per cent. The difference between a return of 9.5 a year and 3.3 per cent is sequence risk.

Henry says: "The historical evidence suggests that it is generally the case that, over a sufficiently long period of time, a portfolio of shares will outperform a portfolio of fixed-income assets. But we don't know when the crashes will occur.

"Now, suppose an investment in fixed income generates 5.6 per cent a year in every one of the 20 years [with no loss years]. Would a rational superannuation fund member prefer a share portfolio or the alternative investment generating a certain 5.6 per cent a year?"

Research undertaken for the Financial Services Institute of Australia (Finsia) by a team from the finance department at Griffith University supports the Henry argument. Published last month, it says: "The retirement wealth of long-term investors with multiple cash flows [annual contributions] is affected by the frequency and magnitude of good and bad returns, and also by the sequence in which those returns occur.

"The potential for defined contribution [accumulation] plan members to experience the worst returns in the worst order should be seen as an important risk."

The question, then, is how to manage this risk. The Finsia paper says: "The age-old cure of diversification between different asset classes does not directly address this problem.

"It is the periodic contributions by members that produce sequencing risk. The fact that the contributions are unequal over time makes the risk more acute.

"As the contributions generally increase over a working life, it leads to them having the worst outcome if they experience the worst returns in the years leading up to retirement."

The Finsia paper argues that one way to deal with the problem is to set the superannuation contribution rate higher in the early years of your working life and gradually bring them down as you approach retirement.

Another option would be to adjust asset allocation during the working life to achieve higher portfolio exposure to growth assets in the early years. This would involve a life-cycle investment approach in which the investment is mostly in equities in the initial and middle years, but switches towards less-volatile assets, such as fixed income, in the years approaching retirement.

The executive vice-president and head of fund manager Pimco Australia, John Wilson, advocates a life-cycle strategy, in which asset allocation is shifted from an overweighting to growth assets to more defensive assets over time, based on the fund member's age, expected retirement date and other circumstances.

"With the current asset allocation of most default superannuation funds, which are 75 per cent invested in growth assets, it is possible to suffer a 30 per cent loss. That does not tally with older workers' attitude to risk."

Wilson says life-cycle strategies "trade away some upside" for greater certainty. "While average performance might be greater for the typical balanced portfolio, more members achieve the desired outcome with a life-cycle approach."

The make-up of Australian superannuation fund assets is unusual compared with the pension schemes of most other developed economies.

According to the Organisation for Economic Co-operation and Development, Australian super funds have a very small allocation to the key defensive asset, fixed income (government bonds and corporate debt securities) and a very large allocation to shares.

Of the 31 countries surveyed by the OECD, Australian super funds' holdings of fixed income, at less than 10 per cent, was the second lowest.

A director of Deloitte Access Economics, Ian Harper, says Australian investors have an "embedded bias" towards equities. "It is not clear what the optimal allocation to fixed income is but Australia is so far away from the rest of the world that this is prima facie evidence that something may need to change," he says.

Australian super funds' low allocation to defensive assets is not new but Harper says the divergence from the pension systems of other countries has widened in recent years.

He says a curious feature of the Australian system is that default investment options in superannuation pension accounts have much the same asset allocations as the default options that most members use during the accumulation phase. Very little account is taken of changing life stages.

Like a number of other commentators, Harper thinks this is a far from ideal arrangement.

Positive figures suggest upswing still has puff

Most of the major markets were showing good returns at the end of September. The Australian share market index, the S&P/ASX 200 accumulation index, rose 14.8 per cent over the 12 months to September 30.

Over the same period, the global share index, the MSCI World (ex-Australia), rose 13.6 per cent, and the main US equity index, the S&P 500, rose 30.2 per cent.

The Australian fixed-income index, the UBS Composite, was up 9.6 per cent, and the international fixed-income index, the Barclays Global Aggregate, was up 12.2 per cent.

The head of investment strategy at AMP Capital, Shane Oliver, says the investment cycle is in an "upswing phase".

But Mr Oliver says: "Numerous uncertainties remain the US fiscal cliff, Spain and China which will result in volatility. But there are none of the normal excesses that signal a downturn in the investment cycle.

"There has been no economic boom, investment is low in the United States and Europe, inflation is low, the private sector has been focused on reducing debt levels, and share markets are not expensive.

"This all suggests that the investment-cycle upswing may have a bit further to go."