Not so super

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Jeremy Cooper headed the Federal Government’s Super System Inquiry.  He is widely acknowledged as having done a terrific job.  The final report is here.   He is also the chairman, retirement income, of Challenger Ltd, a financial services firm that is Australia’s largest seller of annuities to retirees.  An annuity is a promise of fixed number of payments in the future.  For instance, I might pay $500,000 for an annuity that makes payments of $40,000 at the end of each of the next 20 years (for an implied return of 4.96% per year).  An annuity that makes payments until death is a super-annuity — hence the term superannuation.  It was reported in the AFR today that Challenger is on track to sell $1.4 billion of annuities this year, outstripping last year’s $933 million.

It was also reported that Challenger recently launched an advertising campaign which will promote annuities as a safe alternative to leaving pension investments in risky stocks.  You can imagine what the ads will be like — “don’t do what I did, I invested in risky stocks and lost my life savings.  Be prudent and buy an annuity”   In today’s AFR Jeremy Cooper has an opinion piece that argues that Australia’s superannuation system is too heavily invested in equities.  Here is a quote from the piece:  “We need to question just how much exposure to equities we should have in our superannuation system.  Do the returns, even over the very long term, justify the white-knuckle roller-coaster ride that Australian super investors have experienced over the past 10 years?” Mr Cooper notes that 52% of the money in large Australian super funds is invested in equities (about 29% domestic and 23% global equities).   Later in the piece he says “The super industry needs to develop ways of making more concrete promises to ordinary Australians, particularly retirees, who should not be expected to embrace the volatility and uncertainty to which they are now exposed, with so few options to protect themselves.”

The second quote makes it very clear that Mr Cooper is wearing his Challenger hat when making these comments.  That is understandable — he like most of us — has narrow commercial interests to promote.  But the content of the article is not congruent with Jeremy Cooper’s promotion of the broad public interest in the Cooper Inquiry.  The clear suggestion that super fund members who have many years to retirement are not well served by a 52% allocation to equities is not right.  It is in the interests of both the individual and broader society for young workers to absorb the high risk of equities and receive the commensurately high expected returns.

There are only a few rules that investors in large superannuation funds need to follow.  They are:

1.  Save enough today for retirement.

2.  Take an amount of risk that is appropriate to your current circumstances.

3.  Be heavily diversified across asset classes and within asset classes.

4.  Optimise payment of tax.

5.  Minimize fees.

Rule 2 means that the closer you are to retirement the less risk you should take.  But, young workers should take a lot of risk, and that involves holding a lot of equities.  Moreover, equities are tax advantaged in Australia as a result of dividend imputation.  And, even those near to or in retirement need to recognise that they are likely to be retired for 2 or 3 decades, so their investment horizon is also long.  It is well established that one of the most common mistakes of super investors is to not take enough risk for enough time.  Jeremy Cooper speaks with great authority on our super system, so he needs to take care that his comments do not suggest investment strategies (too little risk taking) that are highly damaging in the long run.

I don’t wish too seem too critical of Jeremy Cooper because his leadership of the Super System Inquiry was a notable public service.  I just felt that it wasn’t clear enough in his opinion piece which hat he was wearing.  His piece makes sense in terms of advocating the use of his firm’s products, but it is not wholly consistent with standard advice to pension beneficiaries.

10 Responses to "Not so super"
  1. Sam – it’s standard advice to say that an investor should reduce his/her risk as the investor approaches retirement.  However, I seem to recall reading somewhere that there is nothing in economics or finance theory supporting that advice.  Perhaps you could comment in a future post?  Thank you.

  2. Kien
    If we think of the annual return on a portfolio over any particular length of time being a constant (say 12%) plus a random draw from a normal distribution, then the variance of the return is proportional to (1/T) where T is the investment period.
    Therefore, looking forward the variance of the annual return on the portfolio over 30 years is (1/30) of the variance of the annual return over 1 year.  Investors with farther investment horizons (young investors) have much less uncertainty about what return they will acheive than investors with a short horizon (retirees).
    It is also important that young investors can adjust as they go — saving more if returns are low early in investment period.
    Cheers Sam

  3. Sam – nice one – albeit still to read Cooper’s piece

    a couple of comments

    1. what are risks associated with annuities? i work too long and receive a relatively low return and pay too high a fee for poor advice?

    2. add another rule or maybe subset of optimise tax (and gearing into direct investments)

    seems to me, a lot of wealthier people put too much into suoer and neglect to keep direct investments with appropriate gearing taking advantage of tax free threshold and tax on first income threshold is similar to super income tax rate

    3. another rule – actively manage your owner occupied home – its tax fee investment with long duration and relatively low volatility – it is of course not without capital risk but is a major part of most people’s portfolio v direct or super share holdings 

  4. Annuities in Australia are overpriced.  This is partly due to capital requirements for life insurance firms if products take equity risk (for the insurer).  And the Australian bond market doesn’t have sufficient long tenor instruments.
    However I agree with the statements that individuals would often be better served if improved forms of longevity-risk management were available at reasonable prices in Australia.   The stock-market downturn during the GFC impacted peoples’ ability to retire as planned, and most superannuation doesn’t really allow individuals to manage this with anything but the crudest methods (reducing % in equities).  Retirees are caught between achieving a large enough return to ensure they don’t run out of money and the risk of a downturn with similar consequences.  And this is partly because it is uneconomic to offer reasonably priced lifetime annuities.
    One potential solution is for the government to sell (approximately actuarially fair) group longevity insurance for the tail risk to insurers (say, for people past 85).  This would avoid onerous capital requirements, as insurers can probably cope with risk out to age 85.  And, to be blunt, the government is already implicitly picking up the tab for longevity risk through pensions, so why not offer a product to allow insurers or the public to manage this risk better for themselves should they wish to do so?

  5. Sam,
    This will be heavily wonkish, so apologies in advance.
    Your response to Kien focus on one-period returns, and the associated volatility of one-period returns today vs one-period returns in the future. This is not the right advice for investors with longer-term investment horizons, and is not the argument used by proponents of the “stocks are better for the long-run” view.
    For long-run investors, the analysis ought to be based on stocks’ longer-run returns; I think your use of central limit theorem for one-period returns is a red herring. The key insight is that stock returns have small negative autocorrelations, so that the variance of longer-run returns rises at a lower rate than the horizon (when returns have zero autocorrelation, then the variance of K-period returns is K*the variance of one-period returns).
    Consequently, the per-period volatility of long-horizon returns is lower than the volatility of one-period returns, and it this idea that underlies the “stocks are better for the longer-run” view.
    Alan

  6. Hi Alan
    I don’t disagree.  Kien made reference to the result from the standard intertemporal portfolio selection model with asset prices following a random walk with constant parameters, that the optimal portfolio choice is independent of time to the investment horizon.
    You pointed out that if the asset price evolves with time varying or state varying parameters then the optimal portfolio will change with time.  That is also true if the utility of wealth is state or time dependent or if the investment constraints are time dependent.  I am thinking here of the contribution limits of older investors differing from those of younger investors.
    We both agree that younger workers should take more risk than older workers.  I was just framing the problem in terms of per period returns because that is how most people think about portfolio returns.
    Cheers, Sam
     

  7. Of course neither the article nor other comments pick up on the optimal solution.
    The best solution is to sell annuities at a discount (government subsidy) because the longevity risk is currently born by the taxpayer (get the pension once their money runs out). Whether they spend their super faster than appropriate or just lose it through bad luck or mismanagement is immaterial. The optimal strategy for the government remains the same. Offer annuity pensions that reduce the risk of the recipient collecting the aged pension later on a discount. The size of the discount should be proportionate to the likelihood of them relying on the pension.
    Conversely, in the absence of such a discounted offering from the government, the incentives of all super recipients is to take risks knowing they will receive at a minimum the aged pension. So in such an environment, equities will always be the dominant strategy. What is the point in accepting the government bond rate on your investment for 30 years only to receive a privately funded pension the size of the aged pension thus reducing your government assistance?
    Thanks for your efforts Mr Cooper. My Super is the way forward.

  8. There is a chicken and egg situation going on with regards to long term bonds. Most countries benefit from a systematic yield curve inversion beyond about 15 years but here it’s unlikely to be the case, as the fund managers investing the funds backing the annuities want to be PAID to hold longer term bonds. As a taxpayer, I would rather the aofm minimized it’s interest costs than issued a bond at any price so challenger’s job was made a bit easier. Wouldn’t you?

  9. agree with anothy

    a mispriced or even a low yield annuity is unattractive

    apart from a govt pension and subsidies on rates, utilities,health etc – and two thirds of  australians leave behind a house ie are relatively wealthy

    and not surprising that they can put their other assets in the bank – capital guaranteed, pay no fees and earn at least 6% over the course of the economic cycle 

    where’s the longevity risk in that!

  10. It looks like the review didn’t even touch the most egregious issue; that is that if you die before retiring the funds have no obligation to respect your Will and if you are unmarried at the time they can and will keep your money. A few years ago the head of one of the super funds testified before a Senate committee that the returns quoted were based on this theft and could not continue to be met if these funds were distributed to the deceased estates.

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