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When investment markets are as volatile as they have been during this time of COVID, it’s natural for people to worry about the risk to their superannuation retirement savings. But what are the risks and how can they be measured?
For such a simple little word, risk is extremely difficult to pin down.
In the context of super, and investment generally, risk is generally linked with volatility and uncertainty. By this reckoning, shares and other growth assets are risky; so by tallying up the proportion of growth assets in a super fund’s portfolio you can measure risk.
Growth vs Defensive
Growth investments such as shares are regarded as high risk because their value can fluctuate wildly from day to day and year to year, in ways that are difficult to predict. Yet in the long run – over decades not days – growth investments predictably provide high returns.
Defensive investments such as cash and government bonds are regarded as low risk because your capital is guaranteed and the interest payments on a term deposit or a bond are predictable. Yet, over the long run, growth assets are high risk because your savings may not keep pace with inflation. And in a low interest rate environment with near-zero interest rates such as we are in now, cash is high risk even in the short term.
The graph below highlights the long-term returns of various asset classes over the past 30 years.
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Asset class returns 31 March 1990 to 31 March 2020
Super funds provide details of the proportion of growth and defensive assets in their pre-mixed investment options and often use the terms Growth, Defensive or Balanced in their option names.
The level of growth assets is also used as a proxy for risk by ratings companies such as Chant West and SuperRatings when they categorise funds to compare their investment returns. The problem is, there is ongoing debate about what is a growth asset and what is a defensive asset, especially when it comes to asset classes such as real property, infrastructure and alternative forms of credit.
For more on this debate, see SuperGuide Balanced, Growth, Defensive: What’s in a name? and What is a growth asset? Time to set some standards.
While the growth and defensive asset mix get most of the attention, super funds also provide members with another method of evaluating risk.
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The Standard Risk Measure
Since June 2012, on the instigation of APRA, super funds have been required to include a risk rating for all their investment options. Called the Standard Risk Measure, the aim is to provide members with a simple but consistent means of comparing the risk of different investment options, both within and across super funds.
Risk is measured according to the likely number of negative annual returns over a 20-year period. The lower the number of estimated negative returns, the lower the score on a rating of 1 to 7.
For example, an investment option that fund trustees estimate is likely to produce a negative return less than 0.5 times in 20 years would be in risk band 1, while an investment option likely to produce a negative return less than one year in 20 but more than 0.5 times would be in risk band 2, and so on. You can see all seven risk bands with their estimated negative years in 20 outlined in the table below.
Standard Risk Measure
|Risk band||Risk label||Estimated number of negative annual returns over an 20-year period|
|1||Very low||Less than 0.5|
|2||Low||0.5 to less than 1|
|3||Low to medium||1 to less than 2|
|4||Medium||2 to less than 3|
|5||Medium to high||3 to less than 4|
|6||High||4 to less than 6|
|7||Very high||6 or greater|
You can find the risk rating of investment options on your fund’s website, along with other details such as performance targets, actual past performance over different time periods, and asset allocation.
For MySuper options, the information is clearly set out on a single page called the MySuper dashboard, also available on your fund’s website.
Limitations of the Standard Risk Measure
SuperRatings executive director Kirby Rappell says that although the Standard Risk Measure gives the end user a relatively simple way to understand how risky an option may be, there are a couple of challenges with the measure.
“It doesn’t explain how large the negative return may be; a 2% fall or a 20% fall are quite different experiences in an investor’s mind. Secondly, there can be variations in the assumptions used by providers when calculating risk scores,” he says.
The Standard Risk Measure may also be undermined by a lack of consistency in the labels that funds give their investment options. For example, UniSuper’s Balanced option is in risk band 6, indicating high risk. While over at QSuper, its Balanced option is in risk band 4, or medium risk, which is probably closer to the level of risk members might assume from a balanced asset mix.
While the estimated likelihood of negative years, level of growth assets and investment option labels all tell us something about risk, none of them tells us everything we need to know to make informed decisions.
Types of risk
Super members are exposed to a range of risks including the following:
- Market risks that may impact individual investments or asset sectors at certain times in the investment cycle
- Longevity, or the length of time your savings need to last
- Inflation, which can eat up your investment returns over time
- Sequencing risk, or the risk of a big market fall around the time you retire
- Liquidity risk, or not being able to sell an asset quickly to raise cash or without losing money (such as a term deposit)
- Timing, such as buying and selling assets or switching investment options at the wrong time
- Regulatory risk, as successive governments tinker with the super rules.
SMSF trustees will need to understand and manage all these risks and more. But even if you have your super in a pre-mixed investment option where the fund manages many of these risks internally, you still need to be aware of issues such as your age and how long you’ll be invested, timing, sequencing risk and your tolerance for volatility.
How to manage risk
Not all risks can be controlled. Take regulatory risk. Nobody could have foreseen the COVID pandemic or the Federal Government’s decision to allow people to withdraw up to $20,000 from their super. While the measure was popular, people who emptied their super accounts run the risk of shortchanging their retirement.
However, many risks can be managed. The simplest and most effective way to do this is to diversify your super investments, both across and within asset classes. Even if you opt for a pre-mixed investment option, look for one with an asset mix that suits your time horizon and tolerance for short-term volatility.
The more you can train yourself to ignore the noise and focus on your long-term needs, the more chance compound interest has to weave its magic.
You also need to review your strategy when your circumstances or objectives change. For example, as you get close to retirement you may wish to reduce your exposure to higher risk assets, remembering that you need some exposure to growth investments to ensure your savings last as long as you do.
You might also consider seeking independent professional advice, especially as you near retirement. A good adviser can help develop an investment strategy tailored to your personal circumstances and risk tolerance.
The challenge ahead
The task of understanding risk is a lot to ask of fund members, especially those who are young and new to investing or those who don’t have the time or inclination. Which is why the search continues for a simple but valid way to convey investment risk to members.
Kirby Rappell: “Overall, as balances rise, risk will be a more important measure to members as it is harder to recover from market drops via contributions.
“Building awareness and understanding of risk is likely to be a process that is going to take some time. However, it is an integral part of members setting the right long-term strategy and engaging with their super.”