How to hedge your superannuation fund against recession risk

Recent market turmoil has heightened concerns around superannuation, but UNSW Business School research shows pension fund managers can utilise portfolio insurance strategies to protect people’s later life savings from downside risk

More than half a million Australians are estimated to have depleted their superannuation savings during COVID-19, and the Treasury predicts total withdrawals to reach $42 billion under the early-access scheme before it closes in September. But it's not just people depleting their retirement savings that is creating worry. Recent market turmoil has raised concerns about whether future retirees will have adequate income in later life. 

“I understand this is a difficult decision for the government and individuals alike in balancing the short-term needs and long-term saving goals. But withdrawing superannuation balances while losing jobs could have severe consequences for retirement savings,” warns Dr Mengyi Xu, Senior Research Associate in the ARC Centre of Excellence in Population Ageing Research (CEPAR) and School of Risk and Actuarial Studies at UNSW Business School.

Many people are now considering the need for more sustainable income flows as their future investment objective, says Dr Xu, whose research encompasses sustainable wellbeing in later life.

But what kind of options exist to hedge pension fund portfolios against market risks? Dr Xu recently examined this question in a co-authored paper by evaluating the performance of two major types of portfolio insurance strategies: option-based vs constant proportion. Both options are used on a defined contribution (DC) fund that targets a minimum level of inflation-protected annuity income at retirement.

What is portfolio insurance?

Portfolio insurance is commonly referred to as a hedging strategy used to limit portfolio losses while retaining exposure during a market rebound. In the world of pensions, portfolio insurance strategies are more of a risk management tool for fund managers than an option offered to consumers, explains Dr Xu.

In their paper, Portfolio insurance strategies for a target annuitization fund, three UNSW Business School co-authors including Dr Xu, Professor Michael Sherris, Chief Investigator at CEPAR, and Dr Adam Wenqiang Shao, Associate Investigator at CEPAR, say that accumulated savings in a DC fund at retirement should aim to finance a desired level of consumption during retirement. Indeed, they find that both portfolio insurance strategies – option-based and constant proportion – provide strong protection against downside equity risk in financing a minimum level of retirement income.

The paper shows that a target annuitization fund that is managed by portfolio insurance strategies, provides good retirement outcomes in terms of providing an annuity-based minimum wealth level – basically, extra protection against downside risk.

“The target annuitization fund offers a solution to connecting pre-retirement investment to post-retirement consumption. Such connection helps to address the concern inherent in DC funds that members may not receive adequate and sustainable income from their retirement savings,” explains Dr Xu.

Both portfolio insurance strategies aim to address some deficiency in the current default superannuation fund options that most people invest in today. This is an important insight because few could be immune to the market turmoil that occurred in February and March this year unless their wealth had no exposure to the equity market, adds Dr Xu.

“There are two main types of default investment strategies in Australian superannuation funds. The first one invests in a diversified portfolio where the proportion of each asset remains fixed over time; the second one is usually referred to as a lifecycle or target-date fund in which the growth assets are gradually replaced by safe assets as one approaches retirement,” explains Dr Xu.

But both types of strategies fall short of providing an adequate retirement income, in that they fail to link the pre-retirement accumulation and post-retirement income needs, says Dr Xu. “The lifecycle fund provides some protection against equity market downturn closer to retirement, but targeting a minimum guarantee is not explicitly embedded.”

Insights for fund managers

One of the major concerns for DC fund members today is whether their savings can last for a lifetime, enough to maintain a basic standard of living. 

“Businesses have the most responsibility for designing products that meet individual needs and safeguarding consumers. Individuals have the most information about their own situations and needs – they are most responsible for engaging with the system created by the government and gathering information about the products offered by businesses,” explains Dr Xu.

"Businesses have the most responsibility for designing products that meet individual needs and safeguarding consumers"

Dr Mengyi Xu, Senior Research Associate, UNSW Business School

“Our simulation results show that the portfolio insurance strategies have great potential in managing the downside risk for a target annuitization fund,” says Dr Xu. 

“I imagine if a target annuitization fund were to be offered in reality, employees could choose the target annuitization level (or even vary the level over time), and the fund manager would use portfolio insurance strategies to manage the fund at the backstage," she says.

“If I have to pick one, I’m in favour of the constant proportion portfolio insurance strategy for its overall better downside risk protection. In addition, the constant proportion strategy is easier to communicate and implement."

Future forecast

In theory, life annuities remain one of, if not the most effective instruments to manage longevity risk, i.e. the risk of outliving one’s financial resources, says Dr Xu. Though in practice, fund managers face enormous challenges supplying these products to clients,  given many of the assets necessary are in short supply, continues Dr Xu. 

But individuals are also reluctant to purchase annuities. “They tend to view annuities as an investment rather than insurance products and regard them as poor values. The decreasing annuity rates (the amount of income converted from a given wealth) induced by the low-interest rates and increasing longevity further exacerbate this perception,” explains Dr Xu.

Given those practical issues, the future for annuities looks grim. However, Dr Xu says that the take-up of annuities can be largely affected by government regulations. “The UK had compulsory annuitization at age 75 until 2014/15. In Australia, with the Comprehensive Income Products for Retirement (CIPR) recommended by the Financial System Inquiry and the government support for such products, superannuation funds will offer CIPRs in the future,” she says.

“It is highly likely that annuities will be packaged into a CIPR to provide a sustainable life-long income. When funds start offering CIPRS, we are likely to see an increase in the demand for annuities.”

For more information, please contact Mengyi Xu, Senior Research Associate at ARC CEPAR and School of Risk and Actuarial Studies at UNSW Business School.