Is Superannuation Worth the Risk?

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Is Superannuation Worth the Risk?

This week’s post is inspired by a question I got for my Ask an Expert column in the Fairfax press.

A reader asked whether it was worth adding extra money to super given the balance goes up and down. She can put $5000 in one day, only to see the balance drop by that amount the next, causing her to feel like those savings just got flushed down the toilet.

There’s several different elements that are important to get your head around in thinking about this question, and the word count limit in the newspaper makes giving a complete answer challenging. The podcast format however offers far more flexibility, so let’s take a few minutes to dig into this question, something that I know other people have had go through their mind over the years, and dispel a few misunderstandings.

 

The first really important thing to understand is that superannuation is simply a tax structure for accumulating retirement savings. Other common structures are family trusts or companies.

Superannuation is not an investment in its own right. When you deposit money into your superannuation account it can be invested however you like, including entirely in cash if you wish.

This reader made the common error of thinking about adding money to super as an investment in the stock market. This is completely wrong. Whilst most of us will invest our superannuation to have some stock market exposure, that is a choice that we make. Volatility of your account balance therefore is not the fault of superannuation per se, but rather the investment options that you have chosen.

 

Okay, so now we’ve got clarity that investment risk stems from the investment choices we make within our superannuation account, and has nothing to do with superannuation as a retirement savings structure, next we need to clarify, what is risk?

There are several different types of investment risk. In the context of this reader’s question, she was referring to volatility risk, which is indeed the most commonly thought of type of investment risk. Aside from cash, all investments exhibit a degree of volatility – bonds, property, shares, and alternatives such as managed futures. Some investments, most notably directly owned property, might not feel especially volatile because there’s no easy way to get regular prices. However were you to put your investment property up for auction everyday, guaranteed you would see price fluctuations from one day to the next, and one week and month to the next.

This volatility is a problem if you are a short-term investor. Assets with a high level of volatility provide an increased risk that someone could exit an investment at a lower price then what they went in at. Managing volatility risk then is primarily about investment time frame. Buy an investment on day one, then don’t look at it again for 10 years, and volatility risk evaporates entirely.

As much as volatility can make us uncomfortable as investors, the reality is that it’s essential in generating our returns. The higher returns earned by investing in assets such as shares reflects the compensation that we receive for tolerating this volatility. If shares were as stable as cash in the bank, then very quickly the return on shares would come down to be the equivalent of bank interest. That’s not what any of us want.

Volatility risk then, should actually be seen as a positive for smart investors. Those with less discipline or perhaps intestinal fortitude, stay away from volatile investments, which enables the rest of us to collect their attractive long term rewards.

 

But volatility risk is not the only risk that we investors need to consider. Particularly when planning for retirement, a far more important risk to be considered is longevity risk. Longevity risk is the risk that we might outlive our money.

Longevity risk can be managed in a few different ways. You could work longer, so that your retirement savings need support you for fewer years. You could spend less in retirement. Or you could just not live as long.

None of these are especially attractive solutions, and therefore a better approach is to invest in assets that possess volatility risk, and collect the return premium earned through the acceptance of this risk.

 

When developing your financial plan, your financial advisor will inevitably talk to you about risk tolerance and work towards a risk profile. It could be that you have more than one risk profile. You may have a fairly aggressive risk profile for your retirement savings which are inaccessible for 20 or 30 years, and then a lower risk profile for other savings with a shorter time horizon.

With clarity on your risk profile you can then develop an investment strategy for your superannuation savings that works for you.

You’re superannuation account will normally default to the Balanced option, which will have a bias towards growth assets it’s typically around 70% growth assets and 30% defensive assets such as cash and bonds. You can however tailor this with the different options available in your fund to have more or less growth assets depending on your risk profile. Indeed with the more fully featured wrap superannuation funds you can even have things like term deposits to provide guaranteed fixed rates of return if you wish.

 

The role of your superannuation account is to provide you with income in your retirement. The only risk inherent in superannuation is with respect to the preservation that exists until age 60.

Investment risk is a separate matter, and exists both inside and outside of superannuation. Having clarity around these two separate issues is fundamental to making good decisions around your overall financial plan.

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