Are your tools right?
Projection tools can really help to engage members and build an understanding of how their actions can impact their super savings.
But are your tools giving members the right answers?
For young people projections often deliver a seven figure future balance - an exciting prospect in your twenties, and they can help people closer to retirement to understand what their post-work income may be.
But regardless of the age of the member – most calculators and projection tools treat a person the same. And they often fail to consider the biggest variables in investments – volatility and time.
So what determines a member's retirement balance?
This is an easy question for a fund to answer: money going in – Superannuation Guarantee (SG) contributions and any voluntary contributions (including an allowance for steady wages growth); fees and taxes going out; time and investment returns.
It is simple to plug most of these variables into a projection tool and even account for the long-term nature of super as an investment. But how do tools account for the volatility of returns?
This chart shows the variation in median 5 year returns from 2008 to 2013 . As you can see there is significant variation even in 5 year returns from year to year. By assuming that there is no variation in return, projections can be dangerously misleading.
Source: SuperRatings Fund Crediting Rate Survey SR50 Median Balanced Option as at 30 June 2008 to 30 June 2013.
Two ways to treat returns
Most tools treat returns as a constant. They allow a member to choose their investment option and allocate a rate of return based on the risk profile of the option. If you look at the calculators of most major funds they default to a balanced investment option with a default return of between 7% and 7.5% (which can be adjusted). These tools are known as deterministic.
With these tools, the higher the expected return, that is the greater the exposure to higher returning (riskier) assets, the bigger the retirement income – regardless of timeframe. In this way they do not account for any market fluctuations.
But there is another way to treat returns that takes into account volatility and investment time horizons. Known as a stochastic calculation, this approach shows a projected range of likely retirement income outcomes rather than an absolute. Tools that model based on this approach make an allowance for variable investment returns and consider the impact of timeframes on the likely results.
The stochastic estimate takes into consideration those factors that are within the member’s control – contribution amount, investment strategy, fees - while making allowance for investment volatility and timeframe which are generally outside the member’s (or the fund’s) control.
So where a deterministic calculator may project a retirement income of $50,000 from retirement until age 90, a stochastic tool would provide the member with a likely range, indicating, for instance, that a member has an extremely high chance of achieving an income of $45,000 with some chance of achieving an income of $55,000 over the same timeframe.
So how does this approach benefit members?
A stochastic approach can benefit members in several ways.
Firstly a level of comfort can be gained by showing what a member could view as the worst-case scenario. They can look at the range and either accept the lower end of the range, hoping that the middle or higher end of the range proves to be their outcome. Or they could take actions such as changing their contributions or their investment strategy to improve their range of outcomes.
This approach can also aid members in setting an investment strategy more in line with their appetite for risk – particularly for those members close to retirement. When a member uses a deterministic tool, 10 years out from retirement, invested in a balanced fund the projected result will make no allowance for market volatility. It will just return a result based on a 10 year investment with a constant return of say 7%. In reality the return could vary significantly from year to year and it would better serve the member to see a range result that could show the very real possibility of limited growth or even a negative return. This demonstrates to the member the risk associated with a typical balanced fund, rather than showing an estimate of a steady upward climb.
A stochastic result can also help members to prepare for likely market downturns. The range would demonstrate the very real risk of poor returns and help members to plan and budget based on the lower end of the range. This will lessen the blow of an event such as the GFC and lessen the need for members to significantly adjust their plans (such as a delaying their retirement) following a cyclical period of market volatility.
So in conclusion, most projection tools are giving members an answer that probably isn’t correct and more importantly can be misleading for them. Helping members understand that there is uncertainty in their projected outcomes and planning their expenditure to account for that is a far more useful approach.