A better way of measuring risk

Tuesday 18th August 2020 Penny Pryor

The superannuation industry has grappled with the issue of longevity risk, or the prospect of retirees outliving their retirement savings, for decades. But it has been a nebulous concept for the superannuation fund members themselves to grasp.

The Actuaries Institute has come up with a metric that it hopes may make that risk easier for the fund member to understand. It is called the Long Term Risk Metric (LTRM) and is designed to be complementary to the current Standard Risk Measure (SRM) used in most fund communication.

The SRM estimates the number of years during a 20-year period that a fund or investment choice will experience negative annual returns.

The Actuaries Institute has been working on the LTRM for some years and the Long Term Risk Management Working Group, a Working Group of the Institute’s Superannuation Projections and Disclosure Subcommittee, presented its latest research at their annual conference.

“The Standard Risk Measure alone is not a complete assessment of all forms of investment risk. It does not show the potential for long-term investment returns to be less than what a member may require to meet their objectives at retirement,” David Carruthers, working group member and head of member solutions at Frontier Advisors, told the conference.

“What we want to do is move members away from just looking at the number of negative returns they have in a single year and think about the risk in a long-term sense - the risk of not meeting a certain return such that they will not have as much money as they need in retirement.”

The long-term risk metric (LTRM) seeks to address this risk.

Intra or inter fund advice

Carruthers expects that initially fund members will use the metric to compare internal investment options within a fund.

"I think it should kind of be member focused and something which make sense to the member," he told Industry Moves.

"Most of the use I think should be within the fund for the member."

How a person uses the LTRM will depend on their age and how close they are to retirement. The SRM would still be the most relevant measure of risk for a fund member who needs most of their money in the next five years. But for younger members, who won’t need most of their money for the next 10 years, the LTRM would probably be more applicable. And then members who will need most of their money in the next five to 10 years could consider both.

“Risk is not a simple number. Risk is multi-faceted…with SRM and LTRM we are showing there are two ways of looking at risk,” Ian Fryer, working group member and head of research at Chant West, told the conference.

“If we can give guidance about what sort of risk is possibly more relevant to an individual at a particular point in time, and how that changes over time, I don't think it's too complex. I still think it would be possible for members to use something like that.”

Although initial messaging to members around the concept may be difficult, the LTRM can be a useful tool to highlight the different kinds of risk associated with so-called ‘safe’ assets.

“If it is communicated successfully, for example, then it could potentially help scenarios for example …where a member is switching from a balanced fund to cash because now they will see that cash is labelled as a high risk option in order to achieve their long term goal,” Estelle Liu, working group member and consultant at Rice Warner, said.

“Then that would help them to actually think about whether that is actually what they should be doing because it is not a low-risk option to them.”

Industry and regulator participation

Like the SRM, if the LTRM is going to work for inter fund comparisons then there needs to be standardisation around the assumptions and inputs used to calculate it.

"[Then] the consistency of how everybody in the industry calculates the measure matters," Carruthers says.

"Working out the metric isn’t that hard, getting agreement on the metric might be hard."

The working group will shortly meet with the Australian Prudential and Regulatory Authority (APRA) to discuss the metric and is now seeking feedback from the industry.

"We want agreement firstly amongst the industry that this is useful and then secondly, if it's useful, down to the nitty gritty of how do we calculate it," Carruthers said.

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