Super solution is more than asset mix

Forget the debate about whether Australian super funds should invest more in bonds. Of course they have too much money in shares. Whether we like it or not, thanks to the investment strategies of our super funds, Australians are among the most vulnerable in the world to sharemarket falls. But it is simplistic in the extreme simply to say some of that money should be switched into bonds.

Forget the debate about whether Australian super funds should invest more in bonds. Of course they have too much money in shares. Whether we like it or not, thanks to the investment strategies of our super funds, Australians are among the most vulnerable in the world to sharemarket falls. But it is simplistic in the extreme simply to say some of that money should be switched into bonds.

The fact is that the bonds-shares debate is clouding the real issue facing Australian super funds: how they can deliver the retirement outcomes that members expect with any real degree of certainty.

This is not an easy debate to have. It is a lot easier to say that history has shown shares provide the better long-term returns, retirement is a long-term investment and therefore everyone should just wait the bad times out. That message is simple, it can be proven with lots of graphs and long-term data, and it comes in mighty handy when you have just lost 20 per cent of someone's retirement savings. Or to say that bonds produce steadier returns and should be used more to reduce the volatility of super fund returns. That, too, is obvious.

The more difficult debate revolves around how the funds manage risk and how they should invest to provide the best outcomes for their members.

Think about it for a moment. Let's say Jim, Gina and Genevieve are with the same fund. Jim is 25 and likely to be employed in a job where his income rises during the next 40 years. Gina is in her 30s and about to take maternity leave with her first child. She wants to stay at home while her family is young and return to work part time once all her children are at school. Genevieve is 58 and planning to retire at 60, and has been receiving super for only the past 15 years.

All three are in a balanced super fund that aims to provide a return of 3.5 percentage points above the inflation rate over rolling seven-year periods. For the sake of the argument, we will assume it does.

But are they likely to have a similar retirement? Not on your nelly.

The fact is that variables such as when we are going to retire, how much we earn and when the bulk of our money goes into super play a much bigger role in determining how much income we will have in retirement than whether our fund earns 8 per cent or 5 per cent in any particular year.

Here is a term that will get your head spinning. It is "sequencing risk" and it is a recognition that timing plays a huge role in how well we do from an investment.

A professor of finance at Griffith Business School, Mike Drew, told the recent Conference of Major Superannuation Funds that sequencing risk is the No.1 issue facing defined contribution funds today. (Defined contribution funds are the ones most of us have where how well we live in retirement is determined by how much we put in and what we earn on that money, rather than being set by a predetermined formula, such as a percentage of final salary.)

Drew said a 25 per cent market fall in the five years before retirement destroyed up to 1? times a person's lifetime contributions to super, which was one reason the baby boomers had been hit so hard by the dotcom crash, the subprime lending crisis and the continuing ramifications of the global financial crisis.

Sequencing risk is about when you need to start taking your money out and as investors who took the opportunity to plough a $1 million contribution into super just before the GFC found, it is about when you put in large amounts of money. Get it wrong by being unlucky and your retirement will suffer, regardless of your fund's long-term returns.

One way to deal with sequencing risk is to reduce your exposure to higher-risk assets such as shares at times when a loss would set you back most - such as when you are nearing retirement or have just invested a large swag of money. That could well mean having more in bonds.

But that is not necessarily going to provide the best outcome for Jim, who has plenty of time to wear the risks of the sharemarket.

More targeted options include life-cycle funds that reduce your exposure to shares as you get older, and tail-end protection where the fund takes out insurance against losses as members near the end of their working lives.

But as wiser heads in the industry are arguing, the real challenge revolves around the fundamental issue of how funds make investment decisions. The ratings agencies that produce monthly performance figures for super funds (and the media that report them) are often blamed for this, but in many fund managers' minds the biggest risk they face is not losing money but looking bad compared with their competitors. That is why we see funds measuring themselves against a well-known benchmark and allocating their assets so they don't stand out from the crowd. A recent paper by Russell Investments referred to this as "keeping up with the Joneses".

Unfortunately, that approach has nothing to do with addressing things such as sequencing risk and everything to do with the risk that the fund will lose business.

The chief investment officer of the Future Fund, David Neal, told the conference that one of the problems with this was that great investment opportunities tended to get "risk controlled down" to a negligible level because the fund was more concerned with traditional asset allocation rather than weighing up the merits of different investment opportunities.

He said one of the advantages of working from a clean slate with that fund was that it could look at what it wanted to achieve and build a portfolio around that, rather than be constrained by a fixed strategic asset allocation.

Just how successful the fund will be remains to be seen, but it is not alone in trying to focus more on identifying and achieving outcomes rather than arguing about the ideal mix of equities and bonds.