“Adverse equity markets have probably discouraged most retirees most from investing, so how do you justify them being there while taking into account risk tolerances that are becoming lower?” he asks. “These strategies must make sense if investors are going to stay the course and maintain exposure to growth assets to offset longevity risk.”
What the super industry calls “longevity risk” – the risk of members outliving their retirement savings – provides an opening for derivatives specialists who can help prevent losses when markets crash. Shortly after the financial crisis broke, fund managers began marketing derivatives strategies designed to soften the impact of severe market downturns.
They say that derivatives can lessen the volatility of equity investing – at some expense – and keep members from realising losses that are incurred by redeeming equities and buying cash when markets fall. Frontier Investment Consulting, which advises super funds managing about $116 billion in assets, has spent much of 2011 considering investment strategies for retirees.
“The risk tolerance of our members has changed,” says Kristian Fok, deputy managing director at Frontier.
“How do we encourage them to invest in the assets that will give them inflation protection and stay the course?” Another viable option for funds is to provide annuities, which pay an income stream – that corresponds with an up-front payment – to members for a set time frame. However, this presents long-term counterparty risks for funds.
Can the balance sheets of super funds, or their outsourced providers of annuities, bear the longevity risk of thousands of baby boomers? Fok says the retirement investment products that emerge in coming years will probably blend the certainty of annuities with the risk and return of market exposure.
He says the benefits of strategies using derivatives must be weighed against the potentially large costs that they can accrue. Like insurance premiums, derivatives become more expensive when volatility increases, but this cost can be justified if retirees’ capital is protected. “There’s no point in taking out insurance after the flood, but options may be appropriate for retirees in a longterm strategy,” Fok says.
Super funds must also be aware that derivatives can experience pricing anomalies, such as “basis risk”, when the prices of offsetting investments in a hedging strategy do not move in opposite directions and therefore deliver unexpected returns. For such reasons, Fok warns investors against becoming “over-reliant” on the ability of derivatives to hedge market risk.
“As one tool in a risk management framework, and not used excessively, derivatives have a place,” he says. The investment techniques designed for retirees can also be used to help protect the savings of younger members as they accumulate savings. Super funds’ plans for retirement investment products are gaining momentum as many “decision-makers”, or fund trustees, are among the many baby boomers nearing retirement, Fok says. “It’s top-of-mind for them as well.”