PORTFOLIO POINT: Investors will now have greater clarity on their super fund’s risk profile, thanks to new super risk ratings measures.

Super risk ratings are the latest tool to help investors understand and engage with their superannuation funds.

Developed by the Financial Services Council (FSC) and the Association of Superannuation Funds of Australia (ASFA), with the support of industry regulators, the “standard risk measure'”, as it’s formally known, will have seven bands that range from very low to very high.

They aim to give investors information about how often they are likely to see a negative return in their superannuation fund. Specifically, the super risk ratings look to outline how many times in a 20-year period an investor would expect to see a negative return.

Risk band 1, a very low risk rating, would mean that investors would expect to see a negative return less than half a year every 20 years. Risk band 7, a very high-risk rating, would expect a negative return in six or more years out of 20.

The following table shows the new super risk ratings for superannuation funds – based on the number of negative year returns in a 20-year period.

Thinking about risk is something that every investor needs to do. While the 'super risk rating’ system is designed for less experienced investors, it starts the process of thinking about risk.

There are three other aspects of their investment assets that all investors should be thinking about:

• 1. Their expected returns after fees, taxes and inflation.
  2. Their costs as a function of expected returns.
  3. The biggest portfolio 'drawdown’, or fall in value of their portfolio from the top to the bottom.

Let’s consider how an independent investor might put these three things together.

1. Expected returns after tax and inflation and fees – this is crucial because, if the only consideration an investor had was to avoid years of negative returns, then the option is to invest in cash. However, there are problems with this. A return of 5% a year (around what a reasonable cash account will pay now), becomes about 4.5% after tax at the superannuation fund rate. However, if your super fund has to pay some fees (administration, accounting, compliance and audit fees), this has to come out of the return. Then, inflation takes a bite of 3% a year or more out of the purchasing power of the portfolio. It leaves almost none of the original 5% return left over to increase the value of the portfolio in real (after inflation) terms. This situation only gets worse once any pension drawings are paid from a super fund.

So, a reasonable estimate of returns has to be made along with an estimate of risk. A source of information to do this might be the ASX/Russell Long Term Investment Returns report.

2. A statement of costs as a percentage of expected returns. The financial services industry uses percentages a lot – and I think this often hides the real impact of a fee. An average super fund has total fees of about 1.5% (there is a fair bit of variability depending on whether there are wrap fees, advice fees, transaction fees, management fees etc.). This 1.5% does not sound like a lot but, if the expected return from shares is 10% a year, then this is actually 15% of the expected returns.

For a balanced fund with an expected return of perhaps 7% a year, this fee is actually more than 15% of the expected returns. A great advantage of being an informed investors is the ability to think about what fees are being paid. It is worth, however, adding them all up – superannuation fund administration fees, advice fees, education fees, transaction fees and any investment management fees – and checking that they are not having too big an impact on your expected portfolio returns. Use 1.5% as a benchmark – are your total fees more or less than this.

3. The biggest portfolio 'drawdown’, or fall in value of their portfolio from the top to the bottom. This is important. Not only does an investor need to know how often their portfolio might fall in value (i.e. six years out of every 20), they need to know what the damage might be. For example, in the current period of the Global Financial Crisis, shares fell by about 50% in value from top to bottom. A portfolio that is 50% shares and 50% cash would have fallen by about 25%. This is a significant drawdown. If a person close to retirement was planning on drawing income at a fixed percentage rate, say 4% a year, a 25% fall in the value of their portfolio would mean a 25% drop in retirement income – a pretty significant hit.

The biggest fall in sharemarket values in Australia has been around 50% during a few different episodes:

• The Global Financial Crisis
• The 1987 Crash
• The 1970s Downturn
• The Great Depression

Of course, these figures are average figures. I saw many portfolios belonging to investors that suffered falls of more than 50% because they had exposure to companies that failed or suffered much bigger falls in value.

The Vanguard website, in its investor education section, has some useful information about historical returns and drawdowns for various asset classes that can be used to estimate a 'worse case’ fall in investment value.

Conclusion
The super risk ratings are a good chance to think about the information that we need to understand the possible outcomes from our portfolios. These outline the probability of a negative year of returns. A little more information that we can put together for ourselves, being the expected returns (after fees, taxes and inflation), the fees we pay as a percentage of expected returns and the biggest falls in investment value, puts us in a great position to understand what we expect from our portfolio, and whether this will meet our future goals.