Is Superannuation Worth the Risk?

A Fairfax Press inspired this week’s blog post, Ask an Expert Question.

A reader wondered if it was worth adding more money to the super account, given that the balance fluctuates. She may put in $5000 one day and then see her balance fall by the same amount the next. This makes her feel as if she has just flushed away all of those savings.

The word limit of the newspaper makes it difficult to give a full answer. Podcasts offer more flexibility. Let’s spend a minute to dispel some misunderstandings.

Superannuation, as a tax system for retirement savings, is the first thing you need to know. Family trusts and companies are also common structures.

Superannuation does not constitute an investment. You can invest the money you deposit into your superannuation fund however you want, even in cash.

This reader has made the mistake of thinking that adding money to super is an investment on the stock exchange. I’m afraid that’s not right. While most of us invest our superannuation in order to gain some exposure to the stock market, this is a decision that we make. The volatility of your account balance is, therefore, not due to superannuation but the investment options you choose.

Now that we know investment risk is a result of the choices we make in our superannuation accounts and not superannuation itself as a retirement saving structure, we must clarify what risk actually means.

There are many different types of risk in investing. This reader was referring, in the context of her question, to volatility risk. Volatility risk is the most common type of investment risk. All investments, including bonds, property, and shares, as well as alternatives like managed futures, exhibit some level of volatility. Directly owned property is one of the investments that may not be as volatile because it’s difficult to obtain regular prices. If you were to auction your property every day, you’d see price changes from one week to the next and even one month to the other.

If you’re a short-term investment, this volatility can be a problem. High volatility assets increase the risk of someone exiting an investment at a price lower than what they invested at. The key to managing volatility risk is the investment timeframe. If you buy an investment the first day, don’t touch it for ten years, and volatility risk will disappear.

Volatility is essential to generating returns. It may make us uncomfortable, but it’s necessary. Investments in assets like shares provide higher returns as compensation for the volatility. If shares were as steady as money in the bank, then the return on stocks would quickly be equivalent to bank interest. We don’t want that.

The volatility risk should be viewed as a benefit for intelligent investors. The less disciplined or those with less intestinal fortitude will stay away from volatile investments. This allows the rest of us, who have more patience, to reap their long-term rewards.

Investors must also consider other risks. In particular, when planning your retirement, longevity risk is a much more important factor to consider. The longevity risk is that we may outlive our money.

You can manage longevity risk in several ways. You can work longer so that you don’t need to rely on your retirement savings for as many years. You could reduce your retirement spending. You could also live less.

These are not particularly attractive solutions. A better option is to invest in assets with volatility risk and then collect the premium that comes from accepting this risk.

Your financial advisor will undoubtedly discuss your risk tolerance with you and help you develop a risk profile when developing your financial plan. You may have more than just one risk profile. You might have a high-risk profile with your retirement savings, which you won’t be able to access for 20-30 years. However, a low-risk profile may apply to other savings that are accessible sooner.

You can develop a superannuation investment strategy that is right for you once you have a clear understanding of your risk profile.

Your superannuation will default to the Balanced option. This will give a preference for growth assets. It’s usually around 70% growth assets and 30% defensive assets like cash and bonds. The different options in your fund allow you to tailor your portfolio so that it has more or less growth assets based on your risk profile. Wrap superannuation fund features include term deposits that offer a fixed rate of return.

Your superannuation is there to ensure you have a retirement income. Superannuation only has one risk, and that is the preservation of funds up to age 60.

Investment risk is an entirely separate issue that exists inside and outside superannuation. Clarity around these two issues is essential to make good decisions about your overall financial plan.