The government’s retirement income covenant for super funds has thrown the spotlight back on CIPRs and defensive equity, writes Parametric’s Raewyn Williams.
Lifecycle investing, in particular, has been a useful option for superannuation funds looking to construct a long-term default asset allocation strategy. But it can be done better.
Parametric looks at the value of adding a mid-step defensive equity portfolio allocation to mitigate the rather harsh leap from equities to fixed income that lifecycle strategies typically use.
Take-up of lifecycle portfolios in the super industry has been widespread, accounting for about 37 per cent of total MySuper assets and 31 of the 111 MySuper products currently offered.
My view is that improvements can be made to the asset “buckets” lifecycle strategies typically used as they track the member’s investment horizon.
Parametric’s modelling suggests that the addition of an innovative defensive equity bucket to the typical mix delivers better absolute and risk-adjusted returns to retired members, including a higher income stream, while continuing to de-risk the portfolio through time.
What defensive equity looks like
Defensive equity is constructed by Parametric by physically de-risking part of an equity portfolio (say 50 per cent) and replacing it with short-duration fixed income securities, such as bank bills.
Add to this an option overlay consisting of both short puts and calls. The overlay is fully collateralised with exposure to the underlying securities via an index portfolio.
The short options positions access a volatility risk premium that is meaningful and has demonstrated low correlation to the equity risk premium.
This defensive equity strategy differs from other options-based volatility management strategies by positioning the superannuation fund on the lucrative sell side of the options trade.
Instead of forgoing income to reduce risk, the fund reduces its volatility and downside risk as well as gaining a new source of income.
CIPR is coming
Following the budget announcement, super fund trustees will have to consider the retirement needs and preferences of their members, under a new retirement income covenant.
The government accepted the findings of the Financial System Inquiry that the retirement phase of the superannuation system was under-developed and needed to be better aligned with the overall objective of the superannuation system of providing income in retirement.
Funds looking to design their first CIPR product, the rules of which will soon be finalised, can also make use of a defensive equity option.
Lifecycle investing assumes that with increasing age, super fund members have a lower appetite for risk in their portfolios, and so portfolios are de-risked over time.
There are differences in lifecycle approaches, such as the timing of when de-risking starts and how often changes occur, but the move from a portfolio with a high allocation to growth assets to one with a high allocation to cash and fixed income is common to all strategies.
In recent research, we tested a “classic” simulated lifecycle portfolio that starts with 40 per cent in ASX 200 stocks, 40 per cent in global equities and 20 per cent in global bonds.
Each year, the portfolio withdraws 1 per cent from each growth asset class and contributes 2 per cent to bonds.
After 30 years, the classic portfolio has 10 per cent in ASX 200 stocks, 10 per cent in global equities and 80 per cent in global bonds.
We then modelled the impact of adding a defensive equity (DE) allocation to this portfolio.
The DE lifecycle portfolio starts off looking the same, with 40 per cent in ASX 200 stocks, 40 per cent in global equities and 20 per cent in global bonds.
Each year the portfolio withdraws 1 per cent from each of the growth assets classes and contributes 2 per cent to a defensive equity strategy, instead of bonds.
After 30 years the portfolio has 10 per cent in ASX 200 stocks, 10 per cent in global equities, 60 per cent in defensive equities and 20 per cent in bonds.
The DE portfolio includes short-dated options and cash-equivalent positions.
Both sets of modelling factored in transaction costs, but ignored management fees (which would obviously reduce the returns modelled).
Parametric’s modelling (gross fees, net transaction costs) produced a mean return of 6.7 per cent a year for the defensive equity-enabled lifecycle portfolio and 5.7 per cent a year for the classic lifecycle portfolio.
Importantly for retirees the worst-case annual return for the DE lifecycle portfolio was a 0.5 of a percentage point gain, while the worst return for the classic portfolio was a loss of 1.4 per cent.
The simulated annual distribution from $100,000 invested in the DE lifecycle portfolio was $15,990, compared with $13,590 for the classic.
Adding defensive equity also produced a lifecycle portfolio with a lower annual standard deviation (risk) of 7 per cent, compared with 8 per cent for the classic.
These are not small improvements and demonstrate the compounding benefits of executing a better-fit asset allocation strategy over a long-term investment horizon.
Raewyn Williams is Parametric Australia’s managing director, research.
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