Australians approaching retirement have been ill-served by asset consultants unskilled in risk-management, an actuarial and business consulting firm has said.
Milliman practice leader Wade Matterson said the “industry has been dominated by asset consultants who simply did not have the skills in risk-management strategies”.
“They haven’t been exposed to global trends, and have been driven by an obscene focus on peer-risk. Yes, this is a global problem, but it’s stronger in Australia, especially since the Howard Government’s introduction of choice of fund in 2005.
“It’s ironic that everyone thinks member-choice means members will jump ship, but most members are disengaged, and they don’t.”
From the mid-1990s to the global financial crisis in 2008, the equities markets “did fantastically well”, Matterson said. “Managers, super funds, advisers all took the credit for these returns and are now receiving the same credit for poorer returns.”
“But now volatility is very high, people will sacrifice some of the absolute growth if there is less of the downside.”
The response to funding longevity was usually annuities, Matterson said, “but this is product leading the discussions. We have to step back and realise people have been invested the wrong way”.
“If we get under the skin of this, it’s less about alpha or outperformance. It’s more about managing risk and preserving growth. The debate in Australia has been to tell people to put more money in bonds. Or, if people want to preserve capital, they’re told to put it in cash or very low-risk, like term deposits or annuities.
“But, people in retirement have the most money they will ever have, so although negative returns will really hurt them, positive returns are also a huge benefit. We have to look at risk, and adapt allocations through a risk management strategy to preserve the access to growth while minimising the impact of large drawdowns.
“Why is this not done? In Australia, we just haven’t bothered or had a need due to a favourable economic environment – until now. In the US they tried to do it with target-date fund asset allocation. It was a massive failure, but at least they tried and are now adapting to the lessons that were learnt.”
Risk management strategies were crucial for two reasons: individuals’ behaviours, and the sequence of returns.
First, during market falls, people panicked and moved to cash, which hurt long-term returns by locking in large losses.
Second, market falls combined with withdrawals “in a truly toxic way”, Matterson said.
This sequence-of-returns problem “mathematically puts portfolios on an inescapable downward trajectory”, Matterson said.
Effective risk management strategies aimed to stabilise a fund’s volatility around a target level, such as 10 per cent, and also aimed to cut the fund’s downside exposure during sustained market falls, he said.
Another goal of volatility management was to earn more returns because market volatility tended to decrease during long periods of good market returns.
A futures-based risk management strategy would adjust futures’ positions daily – subject to market-based thresholds – to preserve the fund’s capital on a rolling five-years.
Exchange-traded futures contracts could be used for this strategy because of their high liquidity and the security provided by major exchanges as the counterparty in hedging transactions.
Such contracts would be used to lessen risk relative to long-equity portfolios only, Mattson said.
