## BACKGROUND

A new default superannuation regime was introduced in 2013 under the Stronger Super reforms. Funds were required to obtain a license for a MySuper product which required specific features. One of these was a single diversified investment strategy. The legislation provides for a lifecycle exception to this feature, but only if the lifecycle strategy was based on age only, or age and other prescribed factors.

The majority of funds rebadged their existing balanced options as their MySuper products, but some (predominantly retail) funds introduced new products, a number of them with lifecycle investment strategies. According to the MySuper Market Trends publication by Mercer in January 2014, of the 116 MySuper products approved as of January 2014, 22 had lifecycle investment strategies.

One of the key objectives for MySuper was to simplify comparison between products on the basis of fees and investment returns. The introduction of lifecycle strategies makes investment return comparisons difficult.

This article explores the comparison between balanced and lifecycle funds from the perspective of the member’s expected outcome at retirement, rather than on a time-weighted or portfolio-weighted investment return basis. In other words, what is the effective annual internal rate of return achieved over the whole period of accumulation on a given set of cash flows?

## MODELLING STRUCTURE

In order to assess the outcomes members could expect for different approaches, a simple assumption set and deterministic accumulation construct is used:

## OBSERVATIONS

It is not easy to draw conclusions from this analysis. Estimated outcomes are critically based on model assumptions and ex-ante return expectations. Slight adjustments to these could lead to different results.

MySuper products that differ in their investment strategies (i.e. balanced vs. lifecycle) cannot be compared on a time- weighted or portfolio-weighted return basis. In this context, portfolio-weighted returns are considered to be the linked periodic returns earned in the growth and defensive portions of a portfolio, weighted by the proportional allocation to these asset pools for those various periods. These are different to asset-weighted (or dollar-weighted) returns. Ultimately what matters will be the experience an individual has and the actual outcome achieved through the actual internal rate of return achieved.

It is often overlooked that lifecycle funds may have a much higher growth allocation in earlier years (for younger members) than would’ve been the case in a balanced fund. In a way this counters the lower growth allocations in later years. However, the level of this counter will depend on the early growth proportion, the time at which de-risking starts and the level of growth at retirement.

• Lifecycle funds differ vastly in their design. These differences relate to:
• the characteristics that group members (most strategies use age only);
• initial proportion in growth assets;
• age at which de-risking starts;
• rate and method of de-risking;
• what types of assets are used for the growth and defensive proportions;
• level of growth assets at the end of the accumulation period; and
• whether design is ‘to retirement’ (e.g. QSuper) or ‘through retirement’ (e.g. Mercer).

A key component not addressed in this article is the level of risk employed in the various strategies. Within the range of balanced funds, even funds with similar stated investment return objectives may have very different asset allocation strategies to achieve these, which may well have very different levels of return volatility. The same argument would apply for seemingly similar lifecycle strategies.

The deterministic projections shown have results that are reasonably close for balanced vs. lifecycle funds. Projections can be extended to include stochastic modelling, producing a range of outcomes for each strategy. It can be argued that the range of outcomes will be narrower for lifecycle strategies compared to that of balanced funds, due to the lower expected volatility associated with the higher allocation to defensive assets. This would illustrate the potential upside (i.e. adequacy) sacrificed for a more predictable outcome (i.e. certainty).

Arguably the key risk that needs to be managed is that of member outcomes. This relates not just to adequacy, but also certainty. Proponents of lifecycle strategies will state that this approach assists in managing sequence risk in the period leading up to retirement. With investment in less growth assets in the later stages of a lifecycle strategy, the variability of returns is reduced, which in turn reduces the variability of outcomes for members. The expected average return during this de-risking period is naturally lower, reducing the average expected outcome.

## CONCLUSION

Members’ risks are changing and the investment environment is changing. Assets provide different risk/reward ratios over time. While dynamism is not unique to lifecycle funds the advent of a starkly different default has empowered trustees to be pro-active in assessing risks and responding to them. Whether those dynamic decisions will all add value will be seen in time, but Australian funds are now building robust investment capabilities which will allow such investment flexibility to be applied.

The typical balanced strategy is well suited to some members for some part of their investment lifecycle and in some investment environments. But not for all. The balanced strategy comes with a strongly pernicious effect though. It invites ready comparison with other funds. The behavioural impact of these peer comparisons, that are usually made on annual returns and without risk adjustment, encourages inertia in strategy setting. It creates a sense that departing from that balanced strategy introduces risk.

The key risk that needs to be managed is that of member outcomes. This relates not just to adequacy, but also certainty.

The most important thing that lifecycle defaults have done so far is break the inertia which grows out of balanced defaults and peer relative investing. If trustees feel that their members face changing risk profiles as they move through their lifetime there are now some alternatives for them to consider. As the debates kick off and flourish it will be interesting to see how much we can improve a member’s experience in accumulating contributions and then drawing out incomes in retirement, particularly as account balances inexorably grow.

Article supplied on behalf of the Superannuation Projections and Disclosure Sub-Committee. Other Committee members are: Bill Buttler, Jackie Downham, Ian Fryer, Colin Grenfell, Glenn Langton, David Orford, Richard Starkey and Ray Stevens

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