In order to adequately fund their retirement, Australians have heavily invested their superannuation in growth assets such as equities.
While this can result in good investment returns when markets perform well, it exposes investors to the risk of large losses.
In fact, according to the Organisation for Economic Co-operation and Development (OECD), in 2008 Australian superannuation funds had the second worst investment performance in the 30 OECD countries.
While large losses should not happen very often, they can have a huge impact on individuals entering retirement. Consider an individual, say Sarah, who retired on 1 July 2007, invested her assets in the default balanced fund offered by her superannuation fund, and expected to be able to withdraw a steady income from her account balance until 2029.
Fast forward to 1 July 2009, and Sarah can now only expect to be able to withdraw the same steady income until 2019, based on the same assumptions. The losses incurred by the average balanced fund in Australia over the past two years mean Sarah is now expected to run out of money 10 years earlier.
We believe this level of risk is unacceptable and it is good to see a lot of discussion in the media about approaches to reduce this risk. Unfortunately, many of the approaches available today come at a high cost, either in terms of high annual fees or a large reduction in exposure to growth assets.
Most new retirees can expect to live at least another 20 years, so it is extremely important to retain meaningful exposure to growth assets. Without doing so, a retiree may be locking themselves into a lower than necessary standard of living. However, it is equally important for a retiree to be protected from large losses of the type incurred over the past two years - the balance needs to be right.
To achieve this balance, investors should consider a strategy where the risk taken adjusts in line with the investor's changing needs, throughout both their working life and their retirement. Such a strategy would have the following features:
1. Wealth creation
Investors retain meaningful exposure to growth assets throughout their life, giving them the greatest chance of using positive market returns to create wealth. The strategy should be aimed at generating returns in line with those expected from a typical balanced fund.
2. Wealth protection
As investors approach retirement, they retain an exposure to growth assets but also phase in protection against market crashes.
3. Income security
In retirement, investors retain an exposure to growth assets and retain their wealth protection, but also receive a secure income.
4. Flexibility
Investors have flexibility to adjust their level of wealth protection and income security. They are also not forced to lock their money away for any period of time and can withdraw all or part of their account balance at any time.
5. Low cost
The annual fee paid by the investor should be as small as possible. For example, 0.5 per cent a year should be enough to cover both investment management and protection.
Given the majority of Australians are in the default investment choice provided by their superannuation fund, perhaps superannuation funds should provide a default investment choice where the risk taken by an investor adjusts in line with the investor's changing needs.
Superannuation funds not wanting to change their default investment choice could use this strategy to create an 'Invest for Life' fund to run alongside their default fund. It is possible to do this without the superannuation fund taking any market risk or building new administration or IT systems.
If superannuation funds don't provide a low cost investment choice where the risks are adjusted in line with their member needs, maybe it is time they ask themselves why not.
